Sharpe Ratio

Looking at returns as a raw percentage is deceptive. A trade should not only be measured by the amount of money it made you or the percentage return you gained from the trade. The true measure of success is a high measure of Risk-Adjusted Return. The higher your risk adjusted return, the lower the amount of risk you took to make a higher return, and the more skilled you are as an investor or trader.

The Sharpe ratio is an important and common risk-adjusted return statistic. It subtracts the risk-free rate from the average return, then divides that by standard deviation of returns. It’s easily compared across multiple asset classes since it normalizes return by the standard deviation. Sharpe reveals something true: A higher standard deviation is not automatically bad, with a high average return, it can be very good. The biggest issue is it punishes assets for having extremely positive values since that increases the standard deviation. A higher Sharpe ratio is always better.