Investiční slovník
Sharpe Ratio: Measuring Whether Risk Pays Off
Key takeaways
- The Sharpe ratio measures portfolio return adjusted for the risk-free rate, divided by volatility.
- The higher the Sharpe ratio, the better the reward for the risk taken.
- Values above 1 are considered good, above 2 excellent.
- The Sharpe ratio is useful for comparing two funds or strategies with the same type of risk.
- On its own it says nothing about the absolute level of return or the maximum drawdown.
The Sharpe ratio measures how much return a portfolio generated per unit of risk taken — the higher the number, the more efficiently the portfolio handles risk.
The formula in thirty seconds
Sharpe ratio = (portfolio return − risk-free rate) / standard deviation of returns. The risk-free rate is typically the return on short-term government bonds or a savings account. The standard deviation represents volatility — how much the portfolio's value fluctuates.
Example: a portfolio returned 10%, the risk-free rate is 3%, volatility is 7%. Sharpe ratio = (10 − 3) / 7 = 1.0.
How to read the result
- Below 1: return disproportionately small relative to risk
- 1–2: decent ratio, acceptable for passive investors
- Above 2: excellent — rare in diversified funds
- Negative: portfolio earned less than the risk-free instrument
Where the Sharpe ratio hits its limits
The indicator assumes that risk equals volatility and penalizes even positive swings (when a fund grows a lot). It says nothing about maximum drawdown or how the portfolio behaves in a crisis. Therefore use it together with other metrics such as maximum drawdown or the Sortino ratio (which penalizes only negative swings).
When selecting ETFs or comparing strategies, I recommend combining the Sharpe ratio with a look at what risk is and how to measure it and the overall portfolio structure.
FAQ
What exactly does the Sharpe ratio measure?
It measures portfolio return above the risk-free rate, divided by volatility. It answers: for every percent of risk, how much extra did you earn? The higher the number, the more efficiently the portfolio uses risk.
What Sharpe ratio value is considered good?
Generally a value above 1 is considered acceptable, above 2 excellent. Passive index ETFs typically range around 0.5–1.0 over longer periods, depending on the measurement interval.
Is it worth tracking the Sharpe ratio for ETFs?
Yes, but as a comparative tool. It helps compare two funds within the same asset class. Do not compare the Sharpe ratio of an equity ETF with a bond ETF — the types of risk are entirely different.
What are the limitations of the Sharpe ratio?
It penalizes positive volatility, assumes a normal distribution of returns, and ignores maximum drawdowns. Therefore combine it with other indicators such as the Sortino ratio or maximum drawdown.