Sharpe ratio

Excess return divided by volatility. How much return was earned per unit of risk taken.

A portfolio returning 18.4% against a 7% risk-free rate with 22% volatility scores 0.52.

It is the most widely used risk-adjusted measure and it has known weaknesses. It penalises upside volatility equally with downside; it can be improved by strategies that sell insurance, collecting small premiums until the rare large loss arrives; and it is unstable over short samples.

Compare Sharpe ratios only over identical periods, and treat anything above two with suspicion rather than admiration.

One trap is worth naming because it is common in marketing material. A strategy that sells insurance, collecting small premiums until a rare large loss arrives, posts an excellent ratio right up until the loss. Volatility is not the same as risk of ruin, and the ratio cannot see the difference.