What is the Sharpe ratio?

The economist William Sharpe set it out in 1966 as the reward-to-variability ratio. The swing is measured as the standard deviation of returns, and higher is better. Returns are often not normally distributed, so the ratio can miss the risk of a rare large loss, and smoothed prices for hard-to-value assets can make it look better than it is. Its size also depends on whether returns are measured monthly or yearly.

Say two funds each return 12% in a year when cash pays 4%. One swings by 8 points and has a Sharpe ratio of 1. The other swings by 16 points and has a ratio of 0.5. Simple example. Terms vary by fund.

Investors often compare managers by it, because two funds with the same return can have taken very different amounts of risk to earn it.