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.
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.