What does the Sharpe ratio compare excess returns to?

The Sharpe ratio is designed to measure the performance of an investment by adjusting for its risk. Specifically, it compares the excess return of an investment—meaning the return above the risk-free rate—to the total risk of the investment, which is quantified by the standard deviation of its returns.

This ratio serves as a tool to understand how much additional return an investor receives for the extra risk taken, encapsulating both the upside potential and downside volatility of the asset's performance. By using standard deviation as the risk measure, the Sharpe ratio accounts for all variations in returns, both positive and negative, thus providing a comprehensive view of the investment's risk-adjusted performance.

This understanding is crucial for investors aiming to evaluate portfolios or individual investments, as a higher Sharpe ratio indicates a more favorable risk-return tradeoff.