Sharpe ratio

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The Sharpe ratio, named after William F. Sharpe, who developed it in 1966, measures the performance of a portfolio against a risk-free asset. It is defined as the difference between the returns of the investment and the risk-free return, divided by the standard deviation of the investment (being, a somewhat optimistically limited measurement of its volatility). The higher your Sharpe ratio, the more awesome a hedge fund manager you are. A Sharpe ratio of 4 or more puts you in “I’m so good it hurts and, if I ever knew what hubris was, I just don’t care about it now” territory.

The thing is, Sharpe ratios work really well until they don’t.

Famous Sharpe ratios

• LTCM: 4.35, right up until it imploded, nearly bringing down the global financial system with it.
• Madoff: About 4.
• Berkshire Hathaway: 0.76

See also

• Backtesting
• Black-Scholes option pricing model
• Gaussian distribution