What does the Sharpe ratio adjust for when measuring investment performance?

The Sharpe ratio is a key metric used to evaluate the performance of an investment by adjusting for the risk associated with that investment. It is calculated by taking the return of the investment, subtracting the risk-free rate, and then dividing this result by the standard deviation of the investment's excess return.

This adjustment enables investors to understand how much excess return they are receiving for each unit of risk taken. A higher Sharpe ratio indicates that the investment has a better risk-adjusted return, while a lower Sharpe ratio suggests that the return is not compensating investors adequately for the assumed risk. By focusing on risk as part of the performance evaluation, the Sharpe ratio provides a clearer picture of an investment's effectiveness relative to its volatility. Understanding this metric is essential for making informed investment decisions, particularly in the context of portfolio management where risk tolerance varies among investors.