Sharpe Ratio

A ratio developed by Nobel Laureate Bill Sharpe to measure risk-adjusted performance. It is calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

The Sharpe ratio tells us whether the returns of a portfolio are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio's Sharpe ratio, the better its risk-adjusted performance has been.

Here is an article from Motley Fool that explains how to calculate the Sharpe Ratio in your portfolio. You can do this calculation pretty easily with market data from Yahoo Finance and Excel. http://www.fool.com/Workshop/1998/Workshop980821.htm

The higher the Sharpe Ratio, the better. A lower number is worse. So for example:

NOTE: Volatility, also known as the standard deviation of return, is the statistical measure of risk in a portfolio.

This is for an asset class, not a portfolio, but the idea is the same. Stocks have performed better, on a risk-adjusted basis than Treasury Bonds, because the Sharpe Ratio on stocks is higher than Treasury Bonds. A negative Sharpe Ratio is considered very bad. It means you could have done better, on a risk adjusted basis, holding cash. The point of risk adjusted return is not to look at return in a vacuum, but rather to consider how much risk you had to take in order to generate "excess return" - the amount of return over a market benchmark or the risk free rate i.e. 10 year Treasuries.