Sharpe ratio

The Sharpe ratio asks how much extra return an investment delivered for the volatility it put you through. It takes the return above a baseline — usually the yield on short-term government securities, which carry very little credit risk — and divides it by the standard deviation of returns.

Why it matters

Return alone tells half the story. A fund that earned 13% with wild swings may have been a less efficient choice than one that earned 12% with far smaller swings. The Sharpe ratio puts both on one scale, which makes funds with similar objectives easier to compare.

How to read it

• Higher is better, but only when comparing funds in the same category, over the same period, using the same baseline.
• A negative Sharpe ratio means the fund returned less than the baseline over that period.
• It uses total volatility, so it treats upside and downside swings alike.

Common misconceptions

• “A good Sharpe ratio means low risk.” It means the fund was well compensated for the risk it took in the past. It can still be volatile.
• “It works for every strategy.” It assumes returns are roughly symmetrical. Strategies with rare but large losses can look better on this measure than they really are.
• “It predicts future efficiency.” Like every historical ratio, it describes one window of the past.

In India: Factsheets report Sharpe ratios for many equity and hybrid schemes. The baseline rate and the period used are usually stated in the footnotes — check them before comparing.