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What is the Sharpe ratio?

In one line: The Sharpe ratio measures return per unit of risk: the return above a safe rate, divided by how much the returns swung up and down.

Trading glossary · Updated 2026-10-21

The formula

Sharpe ratio = (return − risk-free rate) ÷ standard deviation of returns

• Return: what the account or fund returned over a period, usually a year.
• Risk-free rate: what you could get with almost no risk, often a short-term US Treasury bill.
• Standard deviation: how much the returns bounced around. Bigger bounces, bigger number.

It was created by economist William F. Sharpe, who later shared a Nobel prize for his work on how prices and risk relate.

A simple example

Two portfolios both returned 10% last year. The risk-free rate was 4%.

• A swung up and down a lot: standard deviation 20%. Sharpe = (10 − 4) ÷ 20 = 0.3.
• B was steadier: standard deviation 8%. Sharpe = (10 − 4) ÷ 8 = 0.75.

Same return. B got there with a much smoother ride, so its Sharpe ratio is higher. A math example, not a promise.

Why it matters

Return alone hides how rough the path was. A bumpy ride is harder to stick with and makes deep Drawdowns more likely.

The Sharpe ratio lets you compare two funds, strategies or backtests on a fair basis: how much return for each unit of Volatility.

A common mistake

Comparing Sharpe ratios built differently. One worked out from daily returns and one from monthly returns, or over different years, aren't apples to apples. Check the period and the risk-free rate used.

Also: standard deviation treats big up days as "risk" too. And it can look calm right up until a rare large loss. A great Sharpe ratio from a short history can hide that.

Questions