What Is the Sharpe Ratio?

Developed by Nobel laureate William F. Sharpe, the Sharpe ratio is one of the most widely used measures of risk-adjusted return in finance. It helps investors understand how much excess return they are earning for the level of volatility they endure. The ratio compares the average return of an investment to a risk-free alternative, then divides by the standard deviation of the investment’s returns. A higher Sharpe ratio generally indicates better risk-adjusted performance.

Formula Overview

The Sharpe ratio formula is expressed as:

In this equation, $R$ represents the average return of the investment, $\mathrm{R\_f}$ is the risk-free rate, and $\sigma$ denotes the standard deviation of returns. Returns and volatility should be measured over the same time period, such as annual or monthly.

Using the Calculator

Enter the investment’s average return, the current risk-free rate (often approximated by Treasury yields), and the standard deviation of the returns. The calculator subtracts the risk-free rate from the average return, converts the difference to decimal form, and divides by volatility to produce the Sharpe ratio. If the result is above 1, the investment is typically considered to have delivered solid risk-adjusted returns. A ratio above 2 is exceptional, while values below 1 may indicate that investors are not being adequately compensated for volatility.

Practical Interpretation

Financial analysts rely on the Sharpe ratio to compare mutual funds, ETFs, or portfolios. Because it accounts for volatility, it helps level the playing field between riskier and more conservative strategies. However, the ratio assumes returns follow a normal distribution and uses standard deviation as the sole risk metric. Investments with skewed or fat-tailed returns may require additional measures like Sortino or Omega ratios to capture downside risk.

Consider a fund with an average annual return of 8% and a standard deviation of 10% when the risk-free rate is 2%. Plugging these numbers into the formula yields a Sharpe ratio of 0.6. If another fund offers a 12% return with the same volatility, its ratio rises to 1.0, indicating better risk-adjusted performance. Investors often seek the highest Sharpe ratio for a given risk tolerance, but the metric should be used alongside other factors like drawdowns, diversification, and investment horizon.

Use this calculator as a quick reference when comparing investment options or reviewing your own portfolio’s performance. While no single metric can capture every aspect of risk, the Sharpe ratio remains a fundamental benchmark in modern portfolio theory.