Sharpe Ratio

How it is measured

The numerator is the return earned above what a risk free asset would have paid over the same period. The denominator is the standard deviation of returns, which treats every deviation from average the same way regardless of direction.

Because it is a ratio, it is comparable across strategies of different sizes and different absolute returns, which is what makes it useful as a common yardstick.

How to read it

A higher figure means more return per unit of variability. Comparisons are only meaningful between strategies measured over the same period, because the risk free rate and the market environment both move.

The important limitation is that standard deviation counts upside and downside identically. A strategy that occasionally produces large gains is penalised for it, even though no investor objects to that kind of variability.

A worked example

Two strategies each return ten percent. One does it in a steady line, the other alternates between large gains and small losses. The second has higher standard deviation and therefore a lower Sharpe ratio, despite never having a worse outcome. That is the measure working as designed, and it is also why it should not be read alone.

The most common mistake

Optimising for Sharpe in isolation. A strategy can raise its Sharpe by selling insurance that pays out steadily and fails rarely but catastrophically. The ratio looks excellent right up until the tail event, because standard deviation does not see risk that has not shown up yet.

How CORVIX uses it

CORVIX reports Sharpe alongside Sortino, which penalises only downside deviation, and alongside maximum drawdown and Calmar. No single ratio is treated as the answer, because each one is blind to something the others catch.

Common questions

What is Sharpe Ratio?

The Sharpe ratio measures how much excess return a portfolio earned for each unit of volatility it took on. It is return above the risk free rate, divided by the standard deviation of returns.

How is sharpe ratio measured?

The numerator is the return earned above what a risk free asset would have paid over the same period. The denominator is the standard deviation of returns, which treats every deviation from average the same way regardless of direction. Because it is a ratio, it is comparable across strategies of different sizes and different absolute returns, which is what makes it useful as a common yardstick.

What is the most common mistake when using sharpe ratio?

Optimising for Sharpe in isolation. A strategy can raise its Sharpe by selling insurance that pays out steadily and fails rarely but catastrophically. The ratio looks excellent right up until the tail event, because standard deviation does not see risk that has not shown up yet.