The Sharpe ratio measures return per unit of risk: portfolio return minus the risk-free rate, divided by volatility. Higher is better.
A Sharpe near 1 is generally considered good for a diversified portfolio over the long run; hedge funds chase higher, single stocks are usually lower.
The ratio treats upside and downside volatility the same and assumes roughly normal returns — useful for comparing similar strategies, not a full risk assessment.
The ratio depends on the period it is measured over, and annualising a monthly figure by multiplying by the square root of twelve assumes returns are independent month to month. They are not: trends and mean-reversion both break that assumption, so Sharpe ratios computed at different frequencies are not directly comparable.
It is also not hard to inflate. A strategy that sells insurance-like risk — options premium, credit, illiquidity — collects small steady gains and reports an excellent Sharpe right up until the loss it was being paid to carry arrives. A high ratio over a short, calm sample describes the sample at least as much as the strategy.
Sortino is the usual response to the symmetry problem: it divides by downside deviation alone, so a strategy is not penalised for the volatility investors actually want. For a portfolio with roughly symmetric returns the two ranks similarly, and where they disagree the disagreement is the informative part.
Frequently asked questions
What is a good Sharpe ratio?
Roughly: below 0.5 weak, around 1 good for a diversified portfolio over the long run, above 2 excellent and rare. Always compare over the same period and market.
What risk-free rate should I use?
A short-term government yield in your own currency — for euro investors, short-dated German bonds or the ECB deposit rate are common choices.
What are the Sharpe ratio's limitations?
It penalizes upside volatility as much as downside, assumes roughly normal returns, and says nothing about tail risk. Use it to compare similar strategies, not as a full risk assessment.