The Sharpe ratio is one of the most widely used metrics for comparing investments with different returns: instead of just looking at how much a fund or portfolio gains, it also accounts for how much volatility had to be endured to achieve it.
The formula
```
Sharpe ratio = (Portfolio return − Risk-free rate) / Portfolio standard deviation
```
How to interpret it
A higher Sharpe ratio means better return per unit of risk taken. Two funds may have the same annual return, but if one achieves it with less fluctuation (lower volatility), it will have a higher Sharpe ratio and, generally, be preferable.
Limitations
It uses standard deviation as its risk measure, which penalizes sharp rises and falls equally, even though an investor is usually only concerned about the drops. That's why it's worth combining it with other metrics (such as the Sortino ratio) before drawing final conclusions.