Sharpe ratio.
In plain English
The Sharpe ratio is a way to compare investments on a risk-adjusted basis. It is calculated as (the portfolio's return minus the risk-free rate) divided by the portfolio's standard deviation. A higher Sharpe ratio means more return per unit of risk. The Sharpe ratio is named after William Sharpe, a Nobel Prize-winning economist; it is one of the most cited risk-adjusted return measures in finance, despite well-known flaws (it penalizes upside volatility the same as downside).
01Why it matters
Two funds with the same 10% annual return are not equivalent if one bounces around 20% per year and the other bounces around 10%. The Sharpe ratio puts them on the same scale. For long-term investors comparing funds or portfolio strategies, it is a more honest measure than raw return.
02The math, step by step
Fund A returned 12% with 18% standard deviation. Fund B returned 9% with 9% standard deviation. Assuming a 4% risk-free rate: Sharpe A = (12-4)/18 = 0.44. Sharpe B = (9-4)/9 = 0.56. Fund B delivered more return per unit of risk despite the lower headline return.
Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.
03What this is NOT
Alpha measures return above what a benchmark would have produced. Sharpe ratio measures return per unit of total risk. They are different lenses on the same question; Sharpe focuses on volatility, alpha focuses on benchmark-relative outperformance.
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