What the Sharpe ratio measures
Two investments can earn the same return while putting you through very different rides to get there. The Sharpe ratio brings return and risk into a single number so the two can be compared on equal terms.
It takes the return an investment earned above a safe baseline — the rate you could have earned with almost no risk, such as a short-term government bond — and divides it by how much the investment’s returns moved around. That measure of movement is called volatility. The result is the amount of return earned for each unit of risk taken.
How to read the number
A higher Sharpe ratio is better, because it means more return for the same amount of risk. As a rough guide, a ratio below 1 is modest, around 1 is respectable, and above 2 is strong — though what counts as good depends on the market and the period being measured.
What matters most is the comparison. Between two strategies measured over the same period, the one with the higher Sharpe ratio delivered its return more efficiently: it did not need to take on as much risk to get there.
A worked example
Suppose two strategies both returned 10% over a year, and the safe baseline was 2%. Both earned 8% above that baseline. The first strategy’s returns varied gently, with a standard deviation of 8%, giving a Sharpe ratio of 1.0. The second strategy reached the same 10% but swung far more sharply along the way, with a standard deviation of 16%, giving a Sharpe ratio of 0.5.
The headline return was identical. The Sharpe ratio shows that the first strategy produced it with half the risk, which is the quality the single return figure hides.
Why it matters when testing a strategy
Return on its own is easy to admire and easy to be misled by. A strategy can post a high return by taking large risks that happen to pay off over one stretch of history. The Sharpe ratio is one of the first checks that asks whether the return was worth the risk taken to earn it.
It is not the whole story. A strategy also has to be tested for whether its results hold up outside the period it was built on, which is where problems like overfitting are caught. But the Sharpe ratio is a standard starting point that professionals use, and the course teaches you to read it and reproduce it yourself.