What is the Sharpe Ratio?

The Sharpe Ratio is a financial metric used to measure the risk-adjusted return of an investment. It helps investors understand how much extra return they are earning for the risk taken, compared to a risk-free asset. The formula is Sharpe Ratio = (Rp − Rf) / σp, where Rp is the return of the portfolio, Rf is the risk-free rate, and σp is the standard deviation of the portfolio’s excess return. A higher Sharpe Ratio indicates better performance relative to risk, making it easier to compare different investments or funds. It is especially useful when choosing between portfolios with similar returns but different levels of risk. However, the Sharpe Ratio assumes returns are normally distributed, which may not always hold true. Despite this limitation, it remains a widely used and respected tool in finance for evaluating investment performance.