Sharpe Ratio

The Sharpe ratio measures how much return a strategy earns per unit of volatility endured: the return above the risk-free rate, divided by the standard deviation of returns. It exists to answer a fair question, whether a higher return was skill or just more risk taken, and it answers it only partially.

The math

Strategy A returns 10 percent with 12 percent volatility while cash yields 4 percent: Sharpe of (10 - 4) / 12 = 0.50. Strategy B returns 14 percent with 25 percent volatility: (14 - 4) / 25 = 0.40.

	Strategy A	Strategy B
Return	10%	14%
Volatility	12%	25%
Sharpe ratio	0.50	0.40

On a hypothetical $100,000, B earns $4,000 more in an average year, yet A wins on Sharpe because each point of return cost less turbulence. Over ten years B’s compounding edge could be worth tens of thousands of dollars; the ratio simply says B’s ride will swing twice as hard, and an investor who cannot hold through the swings collects neither figure.

The trap

Chasing high Sharpe ratios as if smoothness were safety. The ratio punishes upside and downside volatility equally, so a strategy that lurches upward scores worse than one that drifts calmly.

Worse, strategies that sell tail risk can post superb ratios for years, collecting steady premiums, then return a decade of gains in one bad month. A beautiful Sharpe computed over a calm period is a description of the weather, not the boat.

The move

Use the ratio for what it can do: comparing similar strategies over the same full cycle, including at least one crisis. Then accept its honest verdict about concentration: a portfolio of 12 conviction holdings will usually show a mediocre Sharpe next to a broad index, because idiosyncratic volatility is the price of differentiated returns.

A stock picker pays that toll knowingly, judges results in compounded dollars over years, and lets volatility-adjusted purity contests belong to the fund marketers.