The Sharpe ratio formula
Sharpe = (Rp − Rf) ÷ σp
Rp is your portfolio's return, Rf is the risk-free rate, and σp is the standard deviation of your portfolio's returns. The numerator is your excess return — the reward you earned for taking risk. The denominator is the amount of risk taken.
What Sharpe ratios mean in practice
- < 0: You lost money vs. just holding T-bills. The risk you took wasn't compensated.
- 0 - 1: Mediocre. Most retail portfolios live here.
- 1 - 2: Good. The S&P 500 long-term is roughly 0.4-0.6 — getting above 1 consistently is solid.
- 2 - 3: Excellent. Top hedge funds aim here over long stretches.
- > 3: Suspicious — either short sample, hidden tail risk, or fraud. Madoff "reported" a Sharpe of ~2.5; real returns over long periods rarely exceed this.
Sharpe's limitations
Sharpe treats all volatility as equally bad, but most investors only care about downside volatility. The Sortino ratio fixes this by only counting negative deviations. Sharpe also assumes returns are normally distributed — which they emphatically are not. Strategies with positive Sharpe but fat left tails (selling out-of-the-money puts, for example) can look great until the moment they don't.