The Sharpe ratio was developed by the Nobel laureate William F. Sharpe to measure risk-adjusted performance. This is important because a return only means anything to an investor if you take risk into account as well.
Let’s say, for example, that investment A gives you a return of 20% and investment B gives you a much lower return of 10%.
So which investment should you pick?
Answer? You don’t know! It’s a trick question because the level of associated risk is not given. If the 10% return on investment A was entirely riskless but the 20% return on investment B also involved you having to stick your head in a hungry lion’s jaw for 10 seconds, then most people would be eminently more satisfied with the lower return provided by investment A.
To calculate the Sharpe ratio is simple. You simply subtract the risk-free rate (something like the 10-year U.S. Treasury bond) from the rate of return on the portfolio and divide the result by the standard deviation of the portfolio returns (essentially its volatility).
How to interpret the Sharpe ratio?
Essentially, the Sharpe ratio indicates whether a given portfolio's returns owe to good investment allocations or excess risk taking.
The higher the number the better. If the number is low it indicates that the portfolio returns owe more to excess risk taking rather than good investment allocations.