@finance.and.quant: The Sharpe ratio measures how much return an investment earns for each unit of risk it takes. Return on its own doesn't tell you much, because two funds can reach their results in very different ways. To calculate it, you take the investment's return, subtract the risk-free rate, and divide by its volatility. The risk-free rate is what you could earn with almost no risk, such as the interest on Treasury bills. Volatility is the standard deviation of returns, which is a measure of how bumpy the ride was. A Sharpe ratio of 1 means you earned 1% of extra return for every 1% of volatility. For example, suppose T-bills pay 4%, Fund X returns 20% with 30% volatility, and Fund Y returns 10% with 6% volatility. Fund X scores 16 ÷ 30 = 0.53, while Fund Y scores 6 ÷ 6 = 1.00. So although X made more money, Y did almost twice as well per unit of risk. This matters because you could borrow money to hold five times as much Y, which would give you X's 30% volatility with a 34% return instead of 20%. For context, the US stock market has come in at roughly 0.3 to 0.5 over the long run, so a fund that stays above 1 for years is doing something unusual. The ratio has weaknesses, though, since it treats big jumps up as risk in the same way as big drops. It can also look high for years on strategies that carry hidden crash risk, and a short track record can make a lucky fund look brilliant. William Sharpe came up with the ratio in 1966 and later shared the 1990 Nobel Prize in economics.

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Monday 05 October 2026 23:04:49 GMT