What is the Sharpe Ratio?

Understanding the Sharpe Ratio

The Sharpe ratio measures risk-adjusted performance by dividing a strategy’s excess return (over the risk-free rate) by its volatility. It tells you how much reward you earn per unit of risk, allowing comparison between strategies with different return profiles.

Calculating Sharpe

• Excess return: Annualized portfolio return minus the risk-free rate.
• Volatility: Standard deviation of returns over the same period.
• Sharpe ratio: Excess return ÷ volatility.

Practical Use

Use rolling Sharpe windows (monthly, quarterly) to monitor regime changes. A rising Sharpe suggests the strategy is delivering better risk-adjusted returns, while a falling Sharpe may signal edge decay or a volatility regime shift.

Limitations

Sharpe assumes returns are normally distributed and penalizes upside volatility the same as downside. High Sharpe ratios derived from short samples often indicate overfitting. Always stress test strategies against fat-tail events and inspect the distribution of returns rather than relying on a single number.