Sharpe Ratio

Risk Metric Investment Wiki — Fundamentals
The Sharpe Ratio is universally used to understand the return of an investment compared to its risk. It measures the excess return (or "risk premium") per unit of deviation in an investment asset. Simply put: for every unit of volatility you stomach, how much extra profit do you earn?
Quick Reference
Type Risk-Adjusted Return Metric
Formula (Return of Portfolio - Risk Free Rate) ÷ Standard Deviation
Good Target > 1.0
Excellent > 2.0+

1.0 The Formula

Basic Form

formulaSharpe = (Rp - Rf) / σp

Where:
Rp = Return of portfolio
Rf = Risk-free rate
σp = Standard deviation of the portfolio's excess return

If two hedge funds both return 20% in a year, you cannot assume they are equally skilled. If Fund A only bought the S&P 500 on massive leverage, they took extreme risk to get that 20% (low Sharpe Ratio). If Fund B achieved 20% by perfectly hedging steady blue-chip stocks, they took very little risk (high Sharpe Ratio).

The Sharpe Ratio penalizes upside volatility exactly the same as downside volatility. An asset that violently rockets up in price will have a lower Sharpe ratio just because it is erratic, frustrating crypto and momentum investors.

3.0 Related Pages

Beta

Both Sharpe and Beta measure volatility, but Beta measures it relative to the market, whereas Sharpe measures standard deviation in isolation.