Understanding the Sharpe Ratio: Risk vs Reward

What is the Sharpe Ratio?

The Sharpe Ratio measures risk-adjusted return. It tells you how much excess return you receive for each unit of volatility (risk) in your portfolio.

The Formula

Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Portfolio Standard Deviation

The risk-free rate is typically the yield on short-term government bonds (e.g., 3-month T-bills).

Interpreting the Sharpe Ratio

Why It Matters

Two portfolios can have the same return, but very different risk profiles:

1. **Portfolio A:** 12% return, 20% volatility → Sharpe = 0.50
2. **Portfolio B:** 10% return, 8% volatility → Sharpe = 1.00

Portfolio B has a lower return but a higher Sharpe Ratio, meaning it delivers more return per unit of risk. For most investors, Portfolio B is the better choice.

Limitations

1. **Assumes normal distribution** — The Sharpe Ratio treats upside and downside volatility equally. A portfolio with large positive surprises gets penalized.
2. **Sensitive to time period** — A 1-year Sharpe can look very different from a 10-year Sharpe.
3. **Risk-free rate matters** — In low-rate environments, Sharpe Ratios appear inflated.

Sharpe vs. Sortino

The Sortino Ratio fixes the biggest weakness of the Sharpe Ratio by only penalizing downside volatility. If your portfolio has high upside variance but low downside risk, the Sortino will be significantly higher than the Sharpe.

Real-World Benchmarks

1. S&P 500 (1994-2024): Sharpe ≈ 0.65
2. 60/40 Portfolio: Sharpe ≈ 0.75
3. All-Weather Portfolio: Sharpe ≈ 0.85

The best hedge funds target a Sharpe Ratio above 1.5, but for most retail portfolios, anything above 0.7 is solid.