DEFINITION of 'Sharpe Ratio'
The Sharpe Ratio is the a measure for calculating riskadjusted return, and this ratio has become the industry standard for such calculations. It was developed by Nobel laureate William F. Sharpe. The Sharpe ratio is the average return earned in excess of the riskfree rate per unit of volatility or total risk. Subtracting the riskfree rate from the mean return, the performance associated with risktaking activities can be isolated. One intuition of this calculation is that a portfolio engaging in “zero risk” investment, such as the purchase of U.S. Treasury bills (for which the expected return is the riskfree rate), has a Sharpe ratio of exactly zero. Generally, the greater the value of the Sharpe ratio, the more attractive the riskadjusted return.
INVESTOPEDIA EXPLAINS 'Sharpe Ratio'
The Sharpe ratio has become the most widely used method for calculating riskadjusted return; however, it can be inaccurate when applied to portfolios or assets that do not have a normal distribution of expected returns. Many assets have a high degree of kurtosis ('fat tails') or negative skewness. The Sharp ratio also tends to fail when analyzing portfolios with significant nonlinear risks, such as options or warrants. Alternative riskadjusted return methodologies have emerged over the years, including the Sortino Ratio, Return Over Maximum Drawdown (RoMaD), and the Treynor Ratio.
Modern Portfolio Theory states that adding assets to a diversified portfolio that have correlations of less than one with each other can decrease portfolio risk without sacrificing return. Such diversification will serve to increase the Sharpe ratio of a portfolio.
Sharpe ratio = (Mean portfolio return − Riskfree rate)/Standard deviation of portfolio return
The exante Sharpe ratio formula uses expected returns while the expost Sharpe ratio uses realized returns.
Applications of the Sharpe Ratio
The Sharpe ratio is often used to compare the change in a portfolio's overall riskreturn characteristics when a new asset or asset class is added to it. For example, a portfolio manager is considering adding a hedge fund allocation to his existing 50/50 investment portfolio of stocks which has a Sharpe ratio of 0.67. If the new portfolio's allocation is 40/40/20 stocks, bonds and a diversified hedge fund allocation (perhaps a fund of funds), the Sharpe ratio increases to 0.87. This indicates that although the hedge fund investment is risky as a standalone exposure, it actually improves the riskreturn characteristic of the combined portfolio, and thus adds a diversification benefit. If the addition of the new investment lowered the Sharpe ratio, it should not be added to the portfolio.
The Sharpe ratio can also help explain whether a portfolio's excess returns are due to smart investment decisions or a result of too much risk. Although one portfolio or fund can enjoy higher returns than its peers, it is only a good investment if those higher returns do not come with an excess of additional risk. The greater a portfolio's Sharpe ratio, the better its riskadjusted performance has been. A negative Sharpe ratio indicates that a riskless asset would perform better than the security being analyzed.
Criticisms and Alternatives
The Sharpe ratio uses the standard deviation of returns in the denominator as its proxy of total portfolio risk, which assumes that returns are normally distributed. Evidence has shown that returns on financial assets tend to deviate from a normal distribution and may make interpretations of the Sharpe ratio misleading.
A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility and uses the semivariance in the denominator. The Treynor ratio uses systematic risk, or beta (β) instead of standard deviation as the risk measure in the denominator.
The Sharpe ratio can also be "gamed" by hedge funds or portfolio managers seeking to boost their apparent riskadjusted returns history. This can be done by:
 Lengthening the measurement interval: This will result in a lower estimate of volatility. For example, the annualized standard deviation of daily returns is generally higher than of weekly returns, which is, in turn, higher than of monthly returns.
 Compounding the monthly returns but calculating the standard deviation from the not compounded monthly returns.
 Writing outofthemoney puts and calls on a portfolio: This strategy can potentially increase the return by collecting the option premium without paying off for several years. Strategies that involve taking on default risk, liquidity risk, or other forms of catastrophe risk have the same ability to report an upwardly biased Sharpe ratio. (An example is the Sharpe ratios of marketneutral hedge funds before and after the 1998 liquidity crisis.)
 Smoothing of returns: Using certain derivative structures, infrequent marking to market of illiquid assets, or using pricing models that understate monthly gains or losses can reduce reported volatility.
 Eliminating extreme returns: Because such returns increase the reported standard deviation of a hedge fund, a manager may chose to attempt to eliminate the best and the worst monthly returns each year to reduce the standard deviation.
VIDEO

Sortino Ratio
A modification of the Sharpe ratio that differentiates harmful ... 
Roy's SafetyFirst Criterion  ...
An approach to investment decisions that sets a minimum required ... 
Downside Deviation
A measure of downside risk that focuses on returns that fall ... 
Modified Sharpe Ratio
A ratio used to calculate the riskadjusted performance of an ... 
Treynor Ratio
A ratio developed by Jack Treynor that measures returns earned ... 
Treasury Bill  TBill
A shortterm debt obligation backed by the U.S. government with ...

How do I use smart beta funds to create a diversified portfolio?
Smart beta funds may use rulesbased strategies to allocate investments across different asset classes and ensure portfolio ... Read Full Answer >> 
What are the advantages and disadvantages of zerobased budgeting in accounting?
The main controversy over the use of the information ratio is that it is an expost measurement often used to predict the ... Read Full Answer >> 
What metrics should I use to evaluate the risk return tradeoff for a mutual fund?
One of the principles of investing is the riskreturn tradeoff, defined as the correlation between the level of risk and ... Read Full Answer >> 
What should you take into consideration when choosing a portfolio management service?
Hiring a portfolio management service or a portfolio manager should be a logical decision based on topics of consideration ... Read Full Answer >> 
What is the difference between a Sharpe ratio and a Traynor ratio?
The Sharpe ratio and the Treynor ratio (both named for their creators, William Sharpe and Jack Treynor), are two ratios utilized ... Read Full Answer >> 
What is the difference between a Sharpe ratio and a Sortino ratio
The Sharpe ratio and the Sortino ratio are both riskadjusted evaluations of return on investment. The Sortino ratio is a ... Read Full Answer >> 
What is the difference between a sharpe ratio and an information ratio?
The Sharpe ratio and the information ratio are both tools used to evaluate the riskadjusted rate of return of an investment ... Read Full Answer >> 
What is a good Sharpe ratio?
The Sharpe ratio is a wellknown and wellreputed measure of riskadjusted return on investment, developed by William Sharpe. ... Read Full Answer >>

Bonds & Fixed Income
Understanding The Sharpe Ratio
This simple ratio will tell you how much that extra return is really worth. 
Personal Finance
Does Your Investment Manager Measure Up?
These key stats will reveal whether your advisor is a league leader or a benchwarmer. 
Markets
The Uses And Limits Of Volatility
Check out how the assumptions of theoretical risk models compare to actual market performance. 
Investing Basics
Determining Risk And The Risk Pyramid
Many investors do not understand how to determine the risk level their individual portfolios should bear. 
Investing
Measure Your Portfolio's Performance
Learn three ratios that will help you evaluate your investment returns. 
Bonds & Fixed Income
Find The Highest Returns With The Sharpe Ratio
Learn how to follow the efficient frontier to increase your chances of successful investing. 
Mutual Funds & ETFs
Understanding Volatility Measurements
How do you choose a fund with an optimal riskreward combination? We teach you about standard deviation, beta and more! 
Active Trading Fundamentals
How The Sharpe Ratio Can Oversimplify Risk
When it comes to hedge funds, this measure is not reliable on its own. 
Investing
Seven Investing Books For Your Summer Reading List
It’s almost 4th of July, the season of summer reading. Picking up a book during your holiday can be a great opportunity to learn more investing. 
Fundamental Analysis
Understanding the Profitability Index
The profitability index (PI) is a modification of the net present value method of assessing an investment’s attractiveness.