William F. Sharpe created the Sharpe ratio in 1966. It is a ratio that investors and economists use to assess the potential return of investment (ROI)
. The Sharpe ratio evaluates the potential returns in relation to the risks. The ratio is also known as the Sharpe measure, Sharpe index, or reward-to-variability ratio.
In simple terms, the Sharpe ratio can be used to evaluate if an investment is worth the risks. Technically, it measures the average return of an investment that goes beyond the risk-free rate per unit of deviation of a particular asset. Therefore, if two different financial instruments are compared in regards to their Sharpe ratio, the asset with a higher Sharpe ratio would be considered better, meaning it has a higher potential of profits in relation to the risks.
So, the higher the value of the Sharpe ratio, the more attractive the investment or trading strategy is. However, even Ponzi schemes
may present a high Sharpe ratio. But the data input of Ponzi schemes are false and do not reflect real returns. So it is important to use the Sharpe ratio properly (with accurate data).
Many banks and big funds managers make use of the Sharpe ratio, combined with other tools, to evaluate their portfolio performance. It may also be applied to financial markets, such as the stock market. However, negative values of Sharpe ratio are not very useful in practice, because the calculation can get close to zero when the volatility
is too high or when the returns are constantly increasing.