Sharpe Ratio

The Sharpe ratio is excess return per unit of volatility: (portfolio return - risk-free rate) / standard deviation of returns. William Sharpe introduced it in 1966, and it remains the default answer to the question every raw return dodges — how much risk did it take to get that number?

Rules of thumb: below 0.5 is weak, around 1.0 is good, and sustained ratios above 2.0 are rare outside of strategies with hidden tail risk. The comparison only works on matching time scales — annualizing a monthly Sharpe means multiplying by the square root of 12, and mixing frequencies is the most common way the ratio gets misquoted.

Two structural blind spots. It penalizes upside and downside volatility equally, so a strategy with occasional huge winning months scores worse than its risk warrants — the Sortino ratio exists to fix exactly this. And because it assumes roughly normal returns, strategies that collect small steady gains while hiding rare catastrophic losses (short-volatility being the classic case) can show beautiful Sharpes right up until the blowup.