The Sharpe ratio calculates the return that an investor will receive for an investment, compared to its risk. It allows investors to quickly identify the risk profile of individual stocks.

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It is calculated by substracting the risk-free rate from the return of a stock. The sum of that calculation is then divided by the standard deviation of that stock, to give you the Sharpe ratio.

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For example, if the risk-free rate is 1%, the return of a stock is 15% and its standard deviation is 12%, then the Sharpe ratio would be (15% – 1%) ÷ 12% = 1.167.

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A Sharpe ratio of 1 is considered good, a Sharpe ratio of 2 or above is considered very good, while a Sharpe Ratio of 3 or above is considered outstanding.