Sharpe Ratio

The calculation

Sharpe ratio = (Rp − Rf) / σp

• Rp = portfolio return over the period.
• Rf = risk-free rate (typically Treasury-bill yield).
• σp = standard deviation of portfolio returns over the period.

The result is the excess return per unit of total volatility. A higher Sharpe is "better" in the sense that the portfolio achieved more return for each unit of risk.

What Sharpe is good at

1. Comparing portfolios with similar return distributions on a risk-adjusted basis.
2. Quick screen for strategies whose returns aren't worth the risk taken.
3. Communicating that "more return" is not always "better return" if the risk is disproportionate.

Where Sharpe falls short

• Non-normal returns — strategies with negative skew (frequent small gains, rare large losses, like option-selling) often show high Sharpe right until they don't.
• Smoothed returns — funds with infrequent valuation (private credit, hedge funds with monthly NAVs) understate volatility and overstate Sharpe.
• Period-dependent — Sharpe over a bull market is not predictive of Sharpe over a bear market.
• Treats upside and downside the same — the Sortino ratio addresses this by using only downside deviation.

Practical use in advisory

Sharpe is a useful sanity check on a strategy's published track record, not a sufficient basis for selection. A strategy with a remarkable Sharpe deserves scrutiny — what is the return distribution, how is it valued, what scenarios would produce a tail event the Sharpe number does not anticipate?

How StratiFi thinks about Sharpe ratio

Sharpe is one number among several. The firms that use it well pair it with maximum drawdown, the Sortino ratio, and qualitative analysis of the return distribution. A high-Sharpe strategy with no recent stress in the data is a flag, not a recommendation.