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 (volatility) 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 Sharpe Ratio is 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.

One limitation of the Sharpe Ratio is that it 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's the motivation behind the Sortino Ratio, which only counts downside deviation.