gen-briefly-explain-the-sharpe-ratio-and-one-common-misconceptio-fb39

Briefly explain the Sharpe ratio and one common misconception about it.

# Sharpe Ratio The **Sharpe ratio** measures risk-adjusted return by comparing an investment's excess return (above the risk-free rate) to its volatility: **Sharpe Ratio = (Return - Risk-Free Rate) / Standard Deviation** A higher ratio indicates better risk-adjusted performance—you're getting more return per unit of risk taken. ## Common Misconception **"A higher Sharpe ratio always means a better investment."** This is misleading because the Sharpe ratio assumes returns follow a normal distribution and only measures volatility risk. It can fail to capture: - **Tail risks** (rare but extreme losses) - **Different risk types** (liquidity risk, credit risk) - **Time horizon differences** For example, strategies that collect small steady gains but occasionally suffer catastrophic losses (like selling insurance or options) can show excellent Sharpe ratios—right up until they blow up. The ratio looks backward at volatility but doesn't predict future disasters.