Return per unit of risk
Two funds that both returned 10% last year are not equally good if one swung wildly to get there. The Sharpe ratio, created by Nobel laureate William Sharpe in 1966, measures how much extra return an investment delivered for each unit of volatility it carried. It is the most widely used way to compare risk-adjusted performance.
The formulas
- Excess return = portfolio return − risk-free rate
- Sharpe ratio = excess return ÷ standard deviation of returns
- Sortino ratio = excess return ÷ downside deviation
All figures should be annual and cover the same period.
Worked example
A portfolio returned 10% a year, Treasury bills yielded 4.2%, the annual standard deviation was 15%, and the downside deviation 10%.
- Excess return = 10 − 4.2 = 5.80%.
- Sharpe ratio = 5.80 ÷ 15 = 0.39.
- Sortino ratio = 5.80 ÷ 10 = 0.58.
Reading the ratio
| Sharpe ratio | Usual reading |
|---|---|
| Below 0 | Worse than a risk-free investment |
| 0 to 1 | Typical of a diversified stock fund over long periods |
| 1 to 2 | Good |
| 2 or more | Very good, but check the period |
Broad stock indexes have often shown Sharpe ratios of about 0.3 to 0.6 over decades. Values above 2 are rare and usually come from short or unusually calm periods, or from strategies with hidden tail risk.
Sharpe or Sortino
The Sharpe ratio treats upside and downside swings as equally risky. Most investors only mind losses, so the Sortino ratio divides by the downside deviation, which counts only returns below a target, usually zero or the risk-free rate. A fund with big gains and small losses scores much better on Sortino than on Sharpe.
Getting the inputs
To compute volatility yourself, take monthly returns, calculate their standard deviation and multiply by √12 to annualize it. Fund fact sheets and sites such as Morningstar publish 3-year and 5-year standard deviations and Sharpe ratios.
Limits
The ratio assumes returns are roughly normal, which understates the risk of rare crashes. It can be flattered by smoothing, for example in private assets valued infrequently. Compare only funds measured over the same period, with the same risk-free rate.
This calculator gives estimates for education and planning. It is not investment, tax or legal advice; for decisions about your own situation, talk to a qualified financial professional.