Sharpe Ratio

The Sharpe ratio shows how much return you earned per unit of risk taken. Subtract the risk-free rate from the return, then divide by volatility.

It reveals what a return alone cannot. Making 20% a year through violent swings gives a low Sharpe ratio, while a steady 8% can score higher. The view is that for the same return, the calmer path was the better investment.

Above 1 is generally decent and above 2 is strong. It works better for comparing similar assets than as an absolute standard, though — putting an equity fund's Sharpe ratio next to a bond fund's stretches the measure.

Its weakness is treating upside and downside movement as equally bad. A sharp gain is volatility too, and it lowers the score. That is why the Sortino ratio, which counts only downside moves, is often read alongside it. Short periods also make the figure unstable. A Sharpe ratio computed over a few months is close to chance; three years or more is the minimum for a meaningful comparison.