Sharpe ratio

The Sharpe ratio answers one question: how much return did this portfolio produce for each unit of risk it took on?

Two portfolios can post the same annual return while behaving completely differently along the way. One drifts upwards steadily. The other doubles, halves, and doubles again. The Sharpe ratio is what separates them, because it divides the return by how much the portfolio moved around to get there.

You will find it on the Performance tab of the investments dashboard, in the grid of risk measures below the chart.

How it is calculated

Sharpe ratio = (portfolio return - risk-free rate) / volatility

Each term:

Portfolio return is your annualised return over the selected period.

Risk-free rate is what you could have earned without taking risk. It is subtracted first, because a return you could have had for free is not compensation for anything.

Volatility is the standard deviation of your returns, annualised. It is the measure of how much the portfolio moved around its own average.

The result is the excess return per unit of volatility. A portfolio returning 8% with 8% volatility and one returning 16% with 16% volatility score roughly the same, because the second one took twice the risk to get twice the return.

How to read it

A higher number means more return per unit of volatility. That is the whole interpretation, and it is worth resisting the urge to read more into it.

Gylder does not label a Sharpe ratio as good or bad, and does not compare yours to a threshold. What counts as a reasonable figure depends on the asset class, the period, and what you were trying to do, and any number we picked would be an opinion presented as a fact.

The comparison that does hold is against yourself. The same portfolio measured over the same length of period, before and after a change in strategy, is a like-for-like reading.

What it misses

The Sharpe ratio treats all volatility as risk, including the upward kind. A portfolio that jumps sharply in your favour is penalised exactly as much as one that falls just as sharply, which does not match how most people experience risk.

That is the specific gap the Sortino ratio exists to close: it uses only downside deviation, so gains no longer count against you. Both sit side by side in the risk grid for that reason.

The ratio also assumes returns are reasonably well behaved. Portfolios concentrated in a few holdings, or holding assets that trade rarely, tend to produce a figure that looks steadier than the position actually is.

Period sensitivity

The Sharpe ratio is not stable across time windows. The same portfolio measured over one year and over five will produce different figures, because both the return and the volatility are calculated over whatever window you selected.

When you change the date range on the Performance chart, every measure in the grid below it recalculates for that window. Comparing a one year Sharpe against a five year one is not a like-for-like reading.