Glossary · Advanced
Sharpe Ratio
Return earned per unit of risk taken — the standard way to compare investments with different volatility.
Sharpe Ratio
The Sharpe ratio asks whether a return was worth the turbulence required to earn it.
The formula
Sharpe = (Return - Risk-free rate) / Standard deviation of returns
The risk-free rate is what you could earn with no risk at all, conventionally a short-dated government bond. Subtracting it means you are measuring only the excess return — the part you were actually paid for taking risk.
How IQInvest reads it
- Below 0 — negative. The risk taken has not been rewarded over this period.
- 0-1 — modest, and the common case. The return did not strongly outpace the volatility.
- Above 1 — strong. The return has been generous relative to the swings involved.
Why it matters
Two shares both return 12% a year. One drifts up steadily; the other doubles and halves along the way. They are not equally good investments, and a plain return figure cannot tell them apart. The Sharpe ratio can.
This is the number that makes returns comparable across very different holdings, which is why it is the standard measure for judging funds.
The limitations
- It treats upside and downside volatility identically. A share that lurches violently upward is punished exactly as much as one that collapses. The Sortino ratio exists to fix this, counting only downside deviation.
- It assumes returns are normally distributed. Real markets have fatter tails than the maths assumes, so crashes are more likely than the ratio implies.
- It is entirely backward-looking, and a period that happened to be calm will flatter it.
Related
- Volatility is the denominator on its own.
- Maximum drawdown shows the worst actual fall, which a reader often feels more than a standard deviation.