Sharpe Ratio and Volatility: Comparing Investments on a Risk-Adjusted Basis
October 29, 2026
A higher return is not necessarily better if it comes with much higher risk. The Sharpe ratio measures return above the risk-free rate per unit of volatility: Sharpe = (portfolio return − risk-free rate) ÷ standard deviation of returns.
Portfolio A earned 9% a year with a standard deviation of 15%, and B earned 7% with a standard deviation of 8%. If the risk-free rate is 3%: A's Sharpe ratio is (9 − 3) ÷ 15 = 0.40, and B's is (7 − 3) ÷ 8 = 0.50. B delivered more excess return for each unit of risk, despite the lower headline return.
Skip the math and get your answer instantly:
Open the Standard Deviation Calculator →Annualizing Volatility
Volatility computed from monthly returns must be scaled to annual terms: multiply by the square root of the number of periods, √12 = 3.464 for monthly. A monthly standard deviation of 4% annualizes to 4 × 3.464 = 13.9%. For daily returns, multiply by √252 (about 15.9). Returns are annualized separately (compounded), and the risk-free rate should match the period. Mixing a monthly standard deviation with an annual return gives a wrong ratio.
| Portfolio | Return | Std. deviation | Risk-free | Sharpe ratio |
|---|---|---|---|---|
| A (stock-heavy) | 9% | 15% | 3% | 0.40 |
| B (balanced) | 7% | 8% | 3% | 0.50 |
| C (bond-heavy) | 4.5% | 4% | 3% | 0.38 |
Interpreting the Number
Rules of thumb: below 0.5 is modest, 1.0 is good, above 2.0 is exceptional and rarely sustained over long periods. Compare Sharpe ratios for the same time period and similar assets. With a normal distribution, about 68% of annual returns fall within one standard deviation of the mean: for A, from −6% to 24%; for B, −1% to 15%. A volatile fund can be acceptable if you can hold through the drawdowns. Leverage can scale returns and risk together, leaving the Sharpe ratio roughly unchanged, so the ratio helps determine whether a high return came from skill or simply from taking more risk.
Limitations
The Sharpe ratio treats upside and downside volatility equally, assumes returns are roughly normal, and can be flattered by strategies that sell insurance-like risks (small steady gains, rare large losses). Short histories give noisy estimates: three years of data produce a wide error range. The Sortino ratio uses only downside deviation, and the maximum drawdown shows the worst peak-to-trough loss. Use several measures.
Practical Use
Use it to compare funds in the same category, to check whether adding an asset improves the portfolio's risk-adjusted return, and to evaluate whether a manager's fees are justified. Past ratios don't guarantee future results. This article is educational, not investment advice.
Frequently Asked Questions
How is the Sharpe ratio calculated?
(Portfolio return − risk-free rate) ÷ standard deviation of returns.
How do I annualize monthly volatility?
Multiply by the square root of 12.
What is a good Sharpe ratio?
About 1.0 or above is considered good.
Does the Sharpe ratio distinguish upside from downside volatility?
No. The Sortino ratio focuses on the downside.
Why can a lower-return portfolio be better?
It may deliver more return per unit of risk.