What is subtracted from a portfolio's return when calculating the Sharpe ratio?

The Sharpe ratio is a measure used to evaluate the risk-adjusted return of an investment or portfolio. It is calculated by taking the difference between the portfolio's return and the risk-free rate of return, which represents the return on an investment with zero risk. This difference is then divided by the standard deviation of the portfolio's excess return, which measures the portfolio's volatility.

By subtracting the risk-free return, the Sharpe ratio assesses how much excess return a portfolio generates per unit of risk compared to a risk-free investment. This is important because it provides investors with insight into whether the additional risk taken by investing in the portfolio is justified by the excess returns achieved.

The risk-free return serves as a benchmark to understand whether the returns from the portfolio are adequate relative to a safe investment. Thus, subtracting the risk-free return allows investors to focus on the excess compensation they receive for taking on additional risk, making it a crucial component in the calculation of the Sharpe ratio.