The Sharpe ratio measures risk-adjusted returns — how much excess return you earn per unit of risk. A higher Sharpe ratio means better compensation for the risk taken.
Portfolio return 12%, risk-free rate 5%, standard deviation 15%. Sharpe = (12% - 5%) ÷ 15% = 0.47. A Sharpe above 1.0 is good; above 2.0 is excellent.
Sharpe helps compare investments with different risk levels. A 20% return with 30% volatility (Sharpe 0.5) is worse than a 12% return with 10% volatility (Sharpe 0.7). Always consider risk-adjusted returns.
| Investment | Sharpe Ratio | Period |
|---|---|---|
| S&P 500 (1Y) | 1.87 | Through late 2025 |
| S&P 500 (long-term avg) | 0.5–0.96 | 20+ year average |
| S&P 500 (6-month rolling) | 2.0–3.0 | Peak in Nov 2025 |
| Walmart (WMT) | 5.04 | 2025 screening |
| Typical hedge fund | 0.5–1.0 | Long-term average |
Benchmark: Sharpe <1.0 is sub-par, >1.0 is good, >2.0 is strong, and >3.0 is exceptional. The S&P 500's long-term Sharpe around 0.5–0.96 means most diversified portfolios should aim to exceed 1.0 through asset allocation.
Portfolio A: 18% return, 25% std dev, risk-free 5% → Sharpe = (18% - 5%) ÷ 25% = 0.52
Portfolio B: 12% return, 10% std dev, risk-free 5% → Sharpe = (12% - 5%) ÷ 10% = 0.70
Portfolio B has a lower return but a higher Sharpe ratio — it delivers more return per unit of risk. For most investors, Portfolio B is the better choice.
💡 Pro Tip: Sharpe's Blind Spot
The Sharpe ratio treats upside and downside volatility equally. A stock that swings wildly upward gets penalized the same as one that swings wildly downward. For a more nuanced view, use the Sortino ratio, which only penalizes downside deviation.
1. Using too short a time period. A 3-month Sharpe ratio is nearly meaningless. Use at least 3 years of data — ideally 5+ years to capture a full market cycle.
2. Comparing across different asset classes blindly. A bond fund's Sharpe of 1.2 isn't automatically better than a stock fund's 0.8. They serve different portfolio roles. Compare within the same category.
3. Ignoring non-normal distributions. Sharpe assumes returns follow a bell curve. Strategies with fat tails (like options selling) can show great Sharpe ratios until a black swan event wipes out years of gains.
4. Cherry-picking the risk-free rate. Using a 1% T-bill rate instead of the current ~5% makes any portfolio look better. Always use the prevailing risk-free rate for an honest comparison.
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Try Stock Return Calculator →What is a good Sharpe ratio?
Generally: below 0.5 is poor, 0.5-1.0 is acceptable, 1.0-2.0 is good, and above 2.0 is excellent. The S&P 500 historically has a Sharpe ratio around 0.5-0.6. Hedge funds often target 1.0+. Keep in mind that very high Sharpe ratios (3+) over short periods often indicate unsustainable strategies or data mining.
Can a negative Sharpe ratio be good?
No. A negative Sharpe means the investment earned less than the risk-free rate. While you could argue a -0.1 Sharpe is "less bad" than a -0.5 Sharpe, the interpretation breaks down with negative values. In practice, a negative Sharpe signals the investment isn't compensating for its risk.
Sharpe ratio vs. Sortino ratio?
The Sortino ratio only considers downside volatility, ignoring upside swings. This makes it better for evaluating strategies with asymmetric returns (like options). If a strategy has frequent small gains and rare large losses, the Sharpe ratio may look great while the Sortino reveals hidden tail risk.