Sharpe Ratio
Risk-adjusted return measure. Higher is better. 1.0+ is good. Compares excess return to volatility—rewards returns, penalizes risk.
What You Need to Know
Sharpe ratio measures return per unit of risk. Calculate: (Investment Return
- Risk-Free Rate) / Standard Deviation of Returns. Higher values mean better risk-adjusted performance.
Interpretation:
- <0.5: Bad risk-adjusted returns
- 0.5-1.0: Acceptable
- 1.0-2.0: Good
-
2.0: Excellent (rare)
Example: Investment A returns 12% with 20% volatility. Investment B returns 10% with 8% volatility. Risk-free rate is 3%.
- A: (12% - 3%) / 20% = 0.45 Sharpe ratio
- B: (10% - 3%) / 8% = 0.875 Sharpe ratio
Investment B has better risk-adjusted returns despite lower absolute return. You're getting more return per unit of risk taken.
Use Sharpe ratio to compare funds, portfolios, or strategies. Prefer investments with higher Sharpe ratios—they deliver returns more efficiently without wild volatility.
Sources & References
This information is sourced from authoritative government and academic institutions:
- investopedia.com
https://www.investopedia.com/terms/s/sharperatio.asp
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Related Terms in Investment
12b-1 Fee
Hidden mutual fund fee (0.25-1% annually) for marketing and distribution. Comes out of your returns. Avoid funds with high 12b-1 fees.
AUM (Assets Under Management)
Total market value of investments managed by an advisor or fund. Used to calculate 1% annual advisor fees—$500K AUM = $5K/year.
Alpha
Excess return above benchmark. Positive alpha = beat the market. Most actively managed funds have negative alpha after fees.
Bear Market
20%+ sustained market decline from recent peak. Characterized by fear, pessimism, and falling prices. Buying opportunity for long-term investors.
Beta
Volatility compared to market. Beta of 1.0 = moves with market. Beta of 1.5 = 50% more volatile. Measures risk, not return.
Bull Market
20%+ sustained market rise from recent low. Characterized by optimism, economic growth, and rising prices. Opposite of bear market.