The Sharpe ratio measures risk-adjusted returns by calculating excess return per unit of volatility, dividing the difference between portfolio return and risk-free rate by the portfolio’s standard deviation. Higher Sharpe ratios indicate better risk-adjusted performance, helping investors compare strategies and investments with different risk profiles.

Sharpe ratio analysis helps optimize portfolio construction and strategy selection by identifying investments that provide superior returns relative to their risk levels. The ratio has limitations including assumptions about return distributions and risk measures. Understanding Sharpe ratios helps evaluate trading performance and investment efficiency.

Real-world example: A trading strategy generating 15% annual returns with 10% volatility and 3% risk-free rate achieves a Sharpe ratio of 1.2 (15%-3%)/10%, indicating good risk-adjusted performance compared to strategies with lower Sharpe ratios.