The Sharpe ratio compares performance against a risk-free asset.

Rational investors want to maximize their rate of return and minimize the risk of their investment, so they need a measure of risk-adjusted return, a tool that would allow them to compare different securities. Such a comparison would help them allocate their funds in securities providing the highest return for a given amount of risk.

This is how the Nobel prize-winner William Sharpe came up with the famous Sharpe ratio. It is a great way to make a proper comparison between stocks and portfolios and decide which one is preferable in terms of risk and return.

In the nominator, we have the excess return of a stock, and in the denominator, we have the standard deviation of the stock.

Another related topic you might be interested to explore is Standard Deviation.

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Sharpe ratio is among the topics included in the Quantitative Methods module of the CFA Level 1 Curriculum.