What does the Sharpe Ratio assess?

The Sharpe Ratio is designed to evaluate the risk-adjusted performance of an investment portfolio or asset. It does this by comparing the excess return of the portfolio—meaning the return above the risk-free rate—to the portfolio's volatility or standard deviation. This ratio serves as a measure of how well the return compensates for the risk taken. A higher Sharpe Ratio indicates that the portfolio is generating more return per unit of risk, which is a desirable trait for investors.

This focus on risk-adjusted performance is crucial, especially in portfolio management, as it allows investors to understand not just how much return they are earning, but how much risk they are taking to achieve that return. By normalizing returns with respect to risk, the Sharpe Ratio helps investors make more informed decisions by differentiating between portfolios that may have similar returns but varying levels of risk exposure.

Other options, such as performance based on market capital, absolute returns, and net profits, do not take into account the risk element, which the Sharpe Ratio specifically addresses, making it a valuable tool for assessing investment performance in a comprehensive manner.