Sharpe Ratio: Measuring Risk-Adjusted Returns and Understanding Its Limits

Summary

The document presents the Sharpe ratio as excess investment return divided by return volatility, and explains how the measure supports comparisons of strategies and portfolios. It describes annualizing a ratio from periodic returns and gives a worked comparison in which a lower-return portfolio has a higher Sharpe ratio because its volatility is lower. It also discusses applying a trade-level calculation to intraday profit and loss and compares the Sharpe ratio with measures such as Sortino and Treynor.

The examples show how the calculation is interpreted, but the article cautions that the measure treats upside and downside variation alike and can be sensitive to extreme returns. A high-frequency strategy with many small gains may appear unusually strong when measured this way, so the ratio should be read alongside other performance and risk information. The document also stresses consistent return periods and discusses using the metric to assess the effect of an asset on a portfolio; a single historical ratio cannot describe every risk or market condition.

Key ideas

• The Sharpe ratio relates returns above a risk-free rate to the standard deviation of returns.
• Annualizing a periodic Sharpe ratio uses the square root of the number of periods in a year.
• A portfolio with lower returns can have a higher Sharpe ratio if its volatility is sufficiently lower.
• The ratio counts upside and downside volatility alike and may be affected by extreme observations.
• Trade-level and high-frequency calculations require care because the chosen sampling and return series affect interpretation.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.