Sharpe Ratio
The Sharpe Ratio measures risk-adjusted return by dividing excess return over the risk-free rate by standard deviation of returns. Higher is better; above 1.0 is good, above 2.0 is excellent.
Definition
Developed by William Sharpe in 1966, the Sharpe Ratio answers: 'Am I being compensated for the risk I'm taking?' It's the standard institutional measure of strategy quality. Two strategies with identical returns can have very different Sharpe Ratios — the one with less volatility wins. Hedge funds target Sharpe above 1.0; quant firms often above 2.0.
Formula
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) ÷ Standard Deviation of Returns
Example
Strategy returns 15% with 10% std dev, risk-free rate is 5%: Sharpe = (15 − 5) ÷ 10 = 1.0