Sharpe Ratio

The Sharpe Ratio, developed by Nobel laureate William Sharpe, measures how much return an investment generated for each unit of risk it took on. It is calculated by subtracting a risk-free rate (such as the yield on short-term Treasury bills) from the portfolio's return, then dividing by the portfolio's standard deviation of returns over the same period.

A higher Sharpe Ratio means a portfolio delivered more return per unit of volatility, which is generally considered more efficient. Two portfolios can have the same raw return, but the one with the smoother ride — the lower volatility — will have the higher Sharpe Ratio. This is why the metric is so useful for comparing very different strategies, such as a bond-heavy Permanent Portfolio against an all-equity Warren Buffett Portfolio: raw returns alone don't tell you which one used its risk more efficiently.

As a rough rule of thumb, a long-run Sharpe Ratio below 1.0 is common for individual asset classes, around 1.0 is respectable for a diversified portfolio, and sustained readings well above 1.0 are hard to achieve without either leverage or a period of unusually calm markets. Because the ratio depends on the risk-free rate you assume, comparisons are only fair when the same rate is applied — this site uses an assumed 2% annual risk-free rate across every strategy.

One important limitation is that the Sharpe Ratio penalizes upside volatility (big positive months) just as much as downside volatility (big negative months), even though most investors only really mind the downside. That is the motivation behind the Sortino Ratio, which counts only downside deviation. It is also worth pairing the Sharpe Ratio with max drawdown, since a strategy can post an attractive Sharpe Ratio while still subjecting investors to a gut-wrenching peak-to-trough loss along the way.