Sharpe Ratio

The Sharpe Ratio measures risk-adjusted return. Index Balance calculates it automatically alongside other key risk metrics for your portfolio.

Definition

The Sharpe Ratio measures the return earned per unit of risk taken. It is calculated by dividing the excess return of the portfolio (total return minus the risk-free rate) by the annualised volatility of that same portfolio. The higher the ratio, the better the compensation the investor receives for the risk taken.

A Sharpe Ratio above 1 is considered good, above 2 is very good, and above 3 is exceptional. In practice, diversified index fund portfolios typically range between 0.5 and 1.5 depending on the period analysed.

The ratio loses relevance when comparing strategies with very different risk profiles, and it does not distinguish between upside volatility (good) and downside volatility (bad). The Sortino Ratio addresses this by only penalising losses.

Practical example

Your portfolio earned a 9% annual return with 12% volatility. The risk-free rate was 2%. The Sharpe Ratio is (9% - 2%) / 12% = 0.58. This means that for every percentage point of risk taken, your portfolio generated 0.58 extra percentage points of return.