The Sharpe ratio measures a portfolio's risk-adjusted return compared with a risk-free investment.
William F. Sharpe introduced the measure in 1966. Its usual formula subtracts the risk-free rate from a portfolio’s average return and divides the result by the portfolio’s standard deviation. The result estimates how much excess return an investment produced for each unit of total volatility.
A higher Sharpe ratio is generally preferred when comparing investments over the same period and using consistent assumptions. However, it is not a guarantee of future performance. The ratio depends on the selected benchmark for the risk-free rate, the measurement period, and the method used to calculate returns and volatility. It also treats upside and downside variation alike, which is why analysts may use measures such as the Sortino ratio when they want to focus specifically on harmful volatility.