What Is Sharpe Ratio? Risk-Adjusted Returns Explained
· 2 min read
The Sharpe Ratio measures return per unit of risk. It answers: "Am I being compensated enough for the volatility I'm taking on?"
The Formula
Sharpe Ratio = (Strategy Return - Risk-Free Rate) / Standard Deviation of Returns
- Strategy Return: Your CAGR or average return
- Risk-Free Rate: What you'd earn doing nothing (T-bills, ~4-5%)
- Standard Deviation: How much your returns bounce around (volatility)
Example: Strategy earns 12% annually, risk-free rate is 4%, standard deviation is 15%.
Sharpe = (12% - 4%) / 15% = 0.53
How to Read It
| Sharpe Ratio | Interpretation |
|---|---|
| Below 0 | You'd be better off in T-bills |
| 0–0.5 | Low risk-adjusted return |
| 0.5–1.0 | Decent |
| 1.0–2.0 | Strong |
| 2.0+ | Excellent (verify it's not overfitted) |
For context, the S&P 500's long-term Sharpe ratio is roughly 0.4–0.6.
The Problem with Sharpe
Sharpe treats all volatility as risk — both up and down. If your strategy has occasional huge winning days, that increases standard deviation and lowers your Sharpe ratio. That feels wrong.
This is exactly why the Sortino ratio exists — it only penalizes downside volatility.
When Sharpe Is Useful
- Comparing strategies with similar return profiles
- Evaluating how much risk you're taking for your returns
- Quick screening of backtest results
When It's Not
- Strategies with infrequent but large gains (trend following)
- Strategies that are mostly in cash (low volatility inflates Sharpe)
- Comparing strategies with very different time-in-market
Key Takeaway
Sharpe ratio is the most widely used risk-adjusted metric, but it punishes upside volatility the same as downside. Use it as a starting point, then check Sortino for a fairer picture.