The Treynor ratio is used extensively to measure the risk-adjusted return potential of investments. However, investors need to understand that there are also limitations to this approach. Ultimately, the Treynor ratio attempts to measure how successful an investment is in providing compensation to investors for taking on investment risk.

Total risk is equivalent to the sum of the systematic risk and the unsystematic risk. As unsystematic risk is the risk that can be diversified away, according to the efficient market theory, investors should not expect to https://www.investorynews.com/ be compensated by taking on more unsystematic risk. That’s why the Treynor ratio is often considered to be theoretically more accurate. The Treynor Ratio is a portfolio performance measure that adjusts for systematic risk.

The Treynor Ratio is named for Jack Treynor, an American economist known as one of the developers of the Capital Asset Pricing Model. A higher Treynor Ratio is preferable, indicating better risk-adjusted performance. However, the magnitude of the difference between two ratios is not indicative of their relative strength. The beta of the portfolio is a critical factor, and a negative beta renders the Treynor Ratio meaningless. When you are looking at trading performance metrics, like the Treynor Ratio, please make sure you understand what you are measuring.

Trading Performance: Strategy Metrics, Risk-Adjusted Metrics, And Backtest

The Treynor Ratio is a portfolio performance measure that adjusts for systematic – “undiversifiable” – risk. An alternative method of ranking portfolio management is Jensen’s alpha, which quantifies the added return as the excess return above the security market line in the capital asset pricing model. As these two methods both determine rankings based on systematic risk alone, they will rank portfolios identically.

1. This is because some assets may not have a relative index to compare with.
2. For example, let’s say that your stock portfolio returned 21% in the past year and had a beta of 2.4, while the S&P 500 Index Fund returned 10% during the same period.
3. Developed by American economist Jack Treynor, the Treynor Ratio is a way to measure how well a portfolio rewarded investors for the amount of risk it took on, over a certain time period.
4. Investments that can produce higher returns with less risk or the same amount of risk as other investments are generally considered more attractive.

Since we now have an understanding of what the Treynor ratio is and its calculation, we can now talk about how to interpret what is a good Treynor ratio. Next, let’s look at some examples to understand how to calculate the Treynor ratio. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

Difference Between the Treynor Ratio and Sharpe Ratio

The Treynor reward to volatility model, named after Jack L. Treynor, is a measurement of the returns earned in excess of that which could have been earned from a risk-free investment. Thus, Sharpe and Treynor Ratios will offer similar results, i.e. they will come up with the same order of funds. With non-diversified portfolios, market risk is a better measure of risk. Treynor ratio will consider the non-diversifiable element of risk and yield additional risk-adjusted performance metrics. Both the Treynor Ratio and Sharpe Ratio measure the performance of an investment per unit risk, but they do it differently. Another difference is that Treynor Ratio uses historical returns only, while the Sharpe ratio can use either expected returns or actual returns.

The Treynor ratio captures the difference between a portfolio’s total return and the risk-free rate, which is subsequently adjusted for the amount of risk undertaken on a per-unit basis. From the table above, Fund C has the least volatile returns as indicated by the lowest beta value. In fact, it is less volatile than the market benchmark is normally https://www.currency-trading.org/ given a beta value of 1. But it turned out to offer the best return per unit risk taken as shown by the Treynor Ratio. While the Treynor ratio uses beta as a risk assessment tool, the Sharpe ratio assesses risk using the standard deviation of returns. Standard deviation is a measure of the extent of dispersion of returns from the mean or average.

Treynor Ratio vs. Sharpe Ratio

Beta establishes volatility by comparing an asset to an index, which might not always be useful. This is because some assets may not have a relative index to compare with. Standard deviation, on the other hand, works well only with evenly distributed data. Investors can measure the performance of their portfolio and assess if the trading risk is worth it using the Treynor ratio. Treynor ratio falls under the category of performance metrics and is a critical tool for decision-making in investing.

Is the Treynor Ratio graded, and what factors should be considered?

If adding a new fund to the portfolio reduces its Treynor Ratio, it increases the risk involved without adding anything to the returns. Although the amount returned by the stocks was the same, the Treynor ratio shows that the stock with 1.3 beta is a low-risk option. Beta is an indicator of risk, as it determines the movement of a stock relative to an index. For instance, if the investment returns 9% in one year and the risk-free rate is 1% per annum, the excess rate will be 8%. The fund’s beta would likely be understated relative to this benchmark since large-cap stocks tend to be less volatile in general than small caps.

In other words, It measures the excess rate of return generated by the investment for each unit of assumed systematic risk. Therefore, an investor desires a higher ratio value as it indicates a better return per unit of assumed risk. The Treynor Ratio calculates the excess return earned per unit of risk taken by a portfolio.

Hakan Samuelsson and Oddmund Groette are independent full-time traders and investors who together with their team manage this website. If interested, download the Navi app by clicking here, explore funds based on your goals and risk tolerance, and start investing in a few minutes in a 100% paperless manner. Additionally, there are no dimensions upon which to rank the Treynor ratio. When comparing similar investments, the higher Treynor ratio is better, all else equal, but there is no definition of how much better it is than the other investments.

It is a performance metric that measures the return a portfolio generates in excess of the risk-free rate and divides that by the systematic risk. As a measure of the risk-adjusted return of a financial portfolio, Treynor Ratio can be used to compare the performance of investments in different asset classes. Also known as the reward-to-volatility ratio, the Treynor ratio is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.

One of the common uses of the Treynor Ratio is to compare the returns from different funds to know the one that earns more return compared to the amount of risk inherent in it. A fund may seem to be making more returns, but at the same time, the returns may be subject to significantly more volatility than the one that appears to be making a lower return. But you should note that the returns here are of the past, which may https://www.topforexnews.org/ not indicate future performance. So, you shouldn’t rely on this one ratio alone for your investment decisions. Developed by American economist Jack Treynor, the Treynor Ratio is a way to measure how well a portfolio rewarded investors for the amount of risk it took on, over a certain time period. These ratios are concerned with the risk and return performance of a portfolio and are a quotient of return divided by risk.