Performance & Risk Metrics
Sharpe ratio
The excess return of a strategy per unit of volatility, the standard measure of risk-adjusted performance.
Introduced by William F. Sharpe in 1966, the ratio answers a simple question: how much return did you earn for the risk you took? It subtracts the risk-free rate from the portfolio's return and divides by the standard deviation of those returns. A higher number means more reward per unit of risk. As a rule of thumb, an annualised Sharpe above 1 is good, above 2 is excellent, and anything above 3 should be treated with suspicion until it survives out-of-sample testing.
Formula
- E[Rp]
- expected (mean) portfolio return
- Rf
- risk-free rate over the same period
- σp
- standard deviation of the portfolio's excess return
Worked example
A strategy returns 14% a year, the risk-free rate is 2%, and annualised volatility is 8%. The Sharpe ratio is (14 - 2) / 8.
1.50