A ratio developed by Nobel Laureate William F. Sharpe to measure risk-adjusted performance. The Sharpe ratio tells us whether the returns of a portfolio are due to smart investment decisions or the result of excessive risk-taking. This measurement is useful because a fund with higher returns is only a good investment if those higher returns do not come with inappropriately increased risk. The greater a portfolio's Sharpe ratio, the better is its risk-adjusted performance.

The Sharpe ratio is calculated by subtracting the risk-free rate, the return on a 10 year government bond for example, from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

The word "expected" has a specific mathematical meaning. In practice, the Sharpe ratio is calculated using the historical returns of the portfolio.

Unless otherwise mentioned, the Sharpe ratio is based on annual returns and the standard deviation of the portfolio on an annual basis. In many cases, a fund might not have enough years of experience to do a meaningful calculation of the Sharpe ratio. In that case, they sometimes calculate their Sharpe ratio using monthly data (monthly returns, monthly standard deviation) and either report it as their "Monthly Sharpe ratio" or they create an approximation of the annual ratio by multiplying the monthly ratio by the square root of 12. This conversion is invalid if there is any significant serial correlation in the monthly returns, which there are in most cases. In the presence of serial correlation in the monthly returns, an annual ratio extrapolated from monthly data will overstate the annual Sharpe by as much as 65 percent.¹

The Sharpe ratio will be legitimately different depending on your definition of risk-free rate. There is no reason why a 10 year, 30 year, or even a T Bill rate is the more appropriate for the "risk-free return".