What is Sharpe Ratio?
A principle of investing is that there is a connected relationship between generating returns (profit) and taking risk. Sharpe Ratio is a formula that measures whether your returns are large enough to compensate for the amount of risk you are taking.
Sharpe Ratio determines those who are making money due to a few lucky decisions, or if there is a consistent pattern for generating returns (profit).
Sharpe Ratio - The Math
Understanding the math behind calculating Sharpe Ratio isn’t necessary to do well. But in case you are curious check it out here:
Sharpe Ratio = (Rx – Rf) / StdDev Rx
- Rx = Expected portfolio return
- Rf = Risk free rate of return
- StdDev Rx = Standard deviation of portfolio return (volatility)
We built this calculator to help you understand it better:
Why are we using Sharpe Ratio?
When you’re only thinking about returns, it can be easy to get lucky and score big wins. But when it comes to maximizing your Sharpe ratio, luck doesn't cut it. Sharpe Ratio helps us determine those who are making money due to a few lucky decisions, or if there is a consistent pattern for generating returns (profit).
Sharpe ratio standardizes risk and return regardless of investment type or strategy, allowing for fair comparisons among challengers.
Sharpe Ratio - Our Scoring Rubric