How is the Sharpe ratio calculated?

The Sharpe ratio is a key measure used to evaluate the risk-adjusted performance of an investment or a portfolio. It quantifies how much excess return you receive for the extra volatility endured by holding a riskier asset. The formula for the Sharpe ratio is the difference between the return of the portfolio and the risk-free rate, divided by the standard deviation of the portfolio's returns.

This formulation captures the essence of the risk-return trade-off: higher returns should be associated with higher risk. By subtracting the risk-free rate, the Sharpe ratio focuses on the additional return that investors earn over what they would receive from a risk-free investment. Dividing by standard deviation, which measures the portfolio's volatility, provides a standardized measure that can be compared across different investments or portfolios.

For instance, if one portfolio has a higher Sharpe ratio than another, it indicates that it is providing more return per unit of risk, making it a more favorable investment option when assessing performance relative to risk. This clear delineation of return attributable to risk is a core principle in portfolio management and investing.

The alternative calculations you might see confuse the relationship between return, risk, and the risk-free rate, failing to accurately represent the risk-adjusted return that the Sharpe