Sharpe Ratio

What is the Sharpe ratio

The Sharpe ratio is an investment metric that measures a portfolio's return adjusted for risk. It shows how much additional return an investor receives for each unit of risk taken. A higher Sharpe ratio indicates a better risk-to-return ratio.

How the Sharpe ratio works

The Sharpe ratio compares a portfolio's return with the risk-free rate and divides the result by the volatility (standard deviation) of the portfolio.

• A high Sharpe ratio means the investor receives higher returns per unit of risk.
• A low or negative ratio indicates that the risk is not adequately compensated by the return.

Why the Sharpe ratio matters

• Allows different investment strategies to be compared on a common basis.
• Helps select a portfolio with the optimal return/risk ratio.
• It is useful for evaluating the performance of a portfolio or funds over the same period.

Limitations of the Sharpe ratio

• It assumes that returns follow a normal distribution, which is not always accurate.
• It does not account for extreme market events (black swan events).
• It can be misleading when used over very short time frames.

Sharpe ratio on Stonkee

On Stonkee the Sharpe ratio can be tracked for the entire portfolio as well as for individual assets. AI tools alert you if the ratio declines over the long term and suggest possible steps to improve the risk-to-return ratio.

Summary

The Sharpe ratio is a key tool for measuring the efficiency of an investment relative to its risk. However, when interpreting it, you must take its limitations into account and combine it with other metrics, such as the Sortino ratio.