Developed by William F. Sharpe, this calculation measures a ratio of return to volatility. It is useful in comparing two portfolios or stocks in terms of risk-adjusted return. The higher the Sharpe Ratio, the more sufficient are returns for each unit of risk. It is calculated by first subtracting the risk free rate from the return of the portfolio, then dividing by the standard deviation of the portfolio.
Using Sharpe ratios to compare and select among investment alternatives can be difficult because the measure of risk, portfolio standard deviation, penalizes portfolios for positive upside returns as much as the undesirable downside returns.
The Sharpe ratio is calculated as follows: