The Sharpe ratio, developed by Nobel laureate William Sharpe, is the most widely used measure of risk-adjusted return in finance. It answers the question: "How much return am I getting for each unit of risk I'm taking?"

The numerator (Rₚ - Rf) represents the "excess return" - the return above what you could earn with a risk-free investment. The denominator (σₚ) is the portfolio's standard deviation, measuring total volatility.

A key insight is that the Sharpe ratio penalizes both upside and downside volatility equally. This can be a limitation for asymmetric return distributions, but for typical portfolio analysis it provides an excellent standardized comparison metric.

In FactorIQ, we use a "hurdle rate" (default 4%) rather than the traditional risk-free rate. This allows comparison against your personal required rate of return, which may be higher than Treasury yields.