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.

LTCM’s Sharpe ratio was 4.35, right up until it imploded, nearly bringing down the global financial system with it. Madoff’s was about 4.

See also

• Back testing
• Black-Scholes option pricing model
• Gaussian distribution