Sharpe Ratio

The Sharpe ratio measures how much return an investment earns for each unit of risk taken, calculated as the return above the risk-free rate divided by the standard deviation. It lets you compare investments on a risk-adjusted basis rather than raw returns alone. A higher Sharpe ratio means better reward for the risk endured.

Use the Sharpe ratio to compare funds or strategies fairly, since a high return achieved with wild volatility may be worse than a steadier, slightly lower return. As a rough guide, a ratio above 1 is considered good and above 2 is excellent. Because it relies on past data and assumes normal returns, treat it as one input rather than a verdict.

Fund A returns 12 percent with a standard deviation of 15 percent, while Fund B returns 10 percent with a standard deviation of 8 percent. Assuming a 2 percent risk-free rate, Fund B has a higher Sharpe ratio, delivering more return per unit of risk despite the lower headline number.