In my previous post, I defined the Sharpe Ratio. But what is a good Sharpe Ratio? After all, there must be some ballpark threshold to say “this is too low” or “this is high enough.” In this post, I’ll show you what a good and bad ratio looks like and its intuitive meaning, as well as some of its drawbacks.

Suggested Good Sharpe Ratio

According to this, here’s the Sharpe Ratio bracket:

• <1 is bad. 1-1.99 is good. 2-2.99 is great. 3+ is excellent.

Taking this seriously makes no sense at all; in particular because the math behind Sharpe Ratio is not reliable, and also I don’t see how 1.99 is “good” but 2 is “great” all of a sudden.

On a high level these numbers are saying:

• 1-1.99: Alpha’s 1-2X standard deviation. Assuming normal distribution, you need to go 1-2 standard deviations below average performance to lose money. That is, you’ll have 16% to 2.5% chance of losing money.
• 2-2.99: Alpha’s 2-3X standard deviation. Again, assuming normal distribution, it means you’ll lose money 2.5% to 0.15% of the time.
• 3+: You’ll lose money less than 0.15% of the time, assuming normal distribution.

In fantasyland where this is a perfectly good indicator of risk vs. reward, you would just invest in everything with a ratio of 2-3.

…But In Reality

The Sharpe Ratio can be used to compare similar opportunities to each other in an apples-to-apples comparison. Much like EPS. Because the math behind this ratio is goofy, using it as a standalone variable with no context doesn’t make a huge ton of sense.

That said: a ratio of 2-3 is a good sign, because even if the model is somewhat wrong, you can have some safety margin in believing that the reward-to-risk is high.

Big caveat: The Sharpe Ratio is based on past data. Past performance do not indicate future behavior. It’s quite possible a that a portfolio with a ratio of <1 could give you a massive gain while a ratio of 3 yields a massive loss. Examples are when there are certain pivots and catalysts in a company that make past assumptions irrelevant.

So, use 2-3 as a rough ballpark as “hmm, this could be somewhat safe.” But don’t use this as a sole indicator as to whether or not you should invest in something. Instead, this ratio should be one of many things you look at before investing in something.

TLDR: It’s a very rough approximation of risk so you can compare things apples to apples, but not as an absolute indicator of risk.