Measuring Risk-Adjusted Return

A 12% return means little without knowing the risk behind it. The Sharpe ratio divides the return earned above the risk-free rate by the portfolio's volatility, expressing performance in units of risk. A 12% return with 8% volatility (Sharpe 0.94) is far more impressive than the same return with 25% volatility (Sharpe 0.30).

Interpreting the Numbers

Sharpe above 1.0 clears the bar most institutional investors set. Above 2.0 is exceptional — the portfolio earns two full units of excess return for every unit of volatility. Below 0.5, the strategy may not be worth its risk; below zero, Treasuries would have served you better.

Using It in Practice

Compare candidates on the same measurement period and frequency. Monthly data smooths noise; daily data inflates Sharpe ratios. Combine the Sharpe ratio with maximum drawdown and Sortino ratio — which ignores upside volatility — before committing capital to any strategy.