The Sharpe ratio: what it measures and when it misleads.
Return per unit of risk is the most quoted number in a backtest. What a good one looks like, and four ways it flatters a strategy.
What it measures
The Sharpe ratio is return per unit of volatility. Two strategies that both made 20% are not equally good if one swung twice as much to get there. In Finertia it is the annualised return divided by the annualised volatility of daily returns, after trading costs and with no risk-free rate subtracted.
As a rough guide on daily data, around 0.5 is ordinary, 1 is good and 2 or more over several years is rare enough to be suspicious.
Where it misleads
Short periods
A Sharpe from one year of data is very noisy. That is why every metric here carries a confidence interval from a block bootstrap, and why a band that still contains zero means there is no evidence of an edge at all.
The best of many
The highest Sharpe in a parameter sweep is biased upward by the sweep. The deflated Sharpe ratio asks whether it beats what the best of that many random tries would have scored.
Fat tails and rare crashes
Volatility treats a large loss and a large gain the same, and a strategy that sells insurance can show a smooth, high Sharpe until the day it does not. Check the maximum drawdown alongside it.
In-sample numbers
A Sharpe from the data the parameters were chosen on is a description of the fit. Momentum on Apple scored 0.949 there and −0.303 on the years after.
Comparing two Sharpe ratios
A strategy at 0.9 against buy-and-hold at 0.7 is not necessarily better: on a few years of data the difference is often inside the noise. The benchmark test in the workspace measures the difference with standard errors that allow for autocorrelation, and says when it cannot tell them apart.
On real stocks
Simply holding, 2019–2024, Nvidia had the highest Sharpe ratio of the 39 stocks at 1.64 and Disney the lowest at 0.02. Each page sets the three rules against that figure.
- Nvidia (NVDA) · Sharpe 1.64 holding it
- Apple (AAPL) · Sharpe 1.21 holding it
- Bharti Airtel (BHARTIARTL) · Sharpe 1.15 holding it
- Johnson & Johnson (JNJ) · Sharpe 0.26 holding it
- Maruti Suzuki (MARUTI) · Sharpe 0.25 holding it
- Disney (DIS) · Sharpe 0.02 holding it
See it on a real strategy.
Finertia runs these checks on any stock you pick. The free plan runs the backtest; Pro adds the validation.