The Sharpe Ratio

The Sharpe Ratio is a measure of excess return over risk. In a portfolio context, excess return is equal to the return on the portfolio minus the risk-free rate. Risk is measured as the standard deviation of those returns. Thus, the formula is ( Rp - Rf ) / SD, where Rp = return on the portfolio, Rf = risk-free rate, and SD = standard deviation. The risk-free rate is generally the rate on 10-year Treasury bonds.

In my opinion, all investors should track their returns and calculate their Sharpe ratios fairly often. It's an important gauge of whether your returns stem from excessive risk or intelligent investing. In the hedge-fund community, managers are constantly attune to their Sharpe ratios. The best Global Macro funds generally have Sharpe ratios in the range of 1-2, while the S&P is usually below .5, depending on the time-frame. Global Macro funds can generally achieve such high Sharpe ratios because they have the latitude to invest in diverse asset classes, such as commodities, currencies, real estate, stocks, and bonds. Thus, they can achieve low correlation between their investments and minimize their risk. This, in my opinion, is an amazing competitive advantage and it's surprising that only 8% of hedge funds pursue a Global Macro strategy, according to Stefanini's Investment Strategies of Hedge Funds (The Wiley Finance Series).