Sharpe Ratio
Glossary Updated 2026-09-08
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Definition
The Sharpe Ratio is a measure of risk-adjusted return, developed by William F. Sharpe. It calculates the excess return per unit of risk, where risk is measured by the standard deviation of returns.
Calculation
code
1Sharpe Ratio = (Rp - Rf) / σpWhere: Rp = Portfolio return Rf = Risk-free rate σp = Standard deviation of portfolio returns ```
The ratio is typically annualized for comparison purposes.
Interpretation
| Sharpe Ratio | Interpretation |
|---|---|
| < 0 | Strategy loses money after risk-free rate |
| 0 - 0.5 | Poor risk-adjusted returns |
| 0.5 - 1.0 | Acceptable |
| 1.0 - 2.0 | Good |
| > 2.0 | Excellent (verify for overfitting) |
WARNING
Very high Sharpe Ratios in backtesting may indicate overfitting rather than genuine skill.
Limitations
- Assumes returns are normally distributed
- Penalizes upside and downside volatility equally
- Sensitive to the measurement period
- Can be manipulated through leverage or smoothing
- Does not capture tail risk or drawdown behavior