What does the Sharpe ratio measure?

The Sharpe ratio measures the risk-adjusted return of an investment portfolio in relation to a risk-free asset. It provides a way to assess how much excess return an investor is receiving for the additional risk taken compared to holding a risk-free asset, such as government treasury bills.

Calculating the Sharpe ratio involves taking the difference between the portfolio's return and the risk-free rate, then dividing that by the standard deviation of the portfolio’s returns, which represents the risk or volatility of the investment. A higher Sharpe ratio indicates a more attractive risk-adjusted return, suggesting that the portfolio is providing good returns for the level of risk taken.

This metric is particularly useful for comparing the performance of different portfolios or investments in order to determine which delivers better returns per unit of risk. Understanding the Sharpe ratio helps investors make more informed decisions regarding their investment strategies, as it highlights the importance of not just focusing on returns, but also on the risks involved in achieving those returns.