The Sharpe Ratio and the Treynor Ratio are crucial tools in the world of investing. It helps investors evaluate the risk-adjusted returns of their investment portfolios. Understanding these ratios can significantly impact investment decisions, directing investors toward more informed choices.
This short article explores how each ratio works and how they differ.
Main sockets
- Both Sharpe and Treynor ratios are used to understand the risk-adjusted return of an investment.
- The Sharpe ratio divides the excess return by the standard deviation of the investment.
- Instead, the Treynor ratio divides the excess returns by the investment's beta.
What is the Sharpe ratio?
The Sharpe ratio measures the performance of an investment compared to risk-free assets, after adjusting for its risk. It basically tells you how much excess return you receive for the additional volatility of riskier assets.
Formula to calculate Specific ratio:
Sharpe ratio = portfolio standard deviation / portfolio return − risk-free rate
The risk-free rate often refers to the yield on Treasury securities, as they are considered free of credit risk.
What is the Treynor ratio?
American economist Jack Treanor developed this ratio. The Treynor ratio also measures risk-adjusted returns but uses the beta of the portfolio as a measure of risk. Beta evaluates the sensitivity of investment returns to the market as a whole.
What is a good Treynor ratio?
There is no set level at which an investment becomes good or bad. A low Treynor ratio in one year could turn out to be very good the next year if volatility declines or returns increase, or a high Treynor ratio can become worse.
Traynor account
The formula goes as follows:
Treynor ratio = portfolio beta / portfolio return − risk-free rate
Compare Sharpe vs. Trainor
Both ratios are intended to provide insight into the returns earned on investments beyond what Treasury bonds provide, taking into account the risks inherent in the investment. The Sharpe ratio (standard deviation) is used to measure volatility. On the other hand, Treynor ratio is based on beta, focusing on market risk.
The main difference
The primary difference lies in their risk metrics. The Sharpe ratio uses standard deviation, making it suitable for diversified investment portfolios. Whereas the Treynor ratio uses beta, focusing on market risk and is more applicable to well-diversified portfolios.
Determinants
Both ratios have their limitations. The Sharpe ratio does not fully account for risk in portfolios with unusual return patterns.
The Treynor ratio assumes that investors have diversified portfolios. This beta is a full measure of risk. However, this may not always be the case, especially with investments that have a negative beta.
Which ratio is better?
Deciding whether Sharpe or Treynor is better depends on context. For diversified portfolios where market risk is a primary concern, the Treynor ratio may provide more relevant insights.
However, to evaluate individual securities or portfolios that are not fully diversified, the broader risk measure of the Sharpe ratio can be more informative.
What is better than Sharpe ratio?
Some investors turn to the information ratio for a different perspective, where they compare earned returns to a benchmark, rather than a risk-free rate, to assess the ability to generate excess returns from active management.
Sharpe ratio vs information ratio?
The choice between the Sharpe ratio and the information ratio depends on the investment objective. If the goal is to evaluate the reward for incurring additional volatility, the Sharpe ratio is appropriate.
If the focus is on the excess returns generated by the benchmark, which reflects the skill of the portfolio manager, the information ratio becomes more important.
Is a higher Sharpe ratio good?
A higher Sharpe ratio is a good thing because it indicates that the investment provides a greater excess return per unit of risk, making it a preferred choice for investors seeking to increase their return-to-volatility ratio.
Alpha Jensen vs. Sharpe vs. Trainor?
Jensen's Alpha measures the excess return on an investment over what the Capital Asset Pricing Model (CAPM) expects it to earn, based on its inherent risk. The Sharpe ratio evaluates the excess return per unit of total risk (volatility), while the Treynor ratio evaluates the excess return per unit of market risk (beta). Essentially, Jensen's Alpha focuses on performance relative to expected returns under the CAPM, the Sharpe ratio over total risk, and the Treynor ratio over market risk.
How do Trainor's pedigrees compare?
When comparing Treynor ratios, look at the excess return per unit of market risk for different investments. A higher Treynor ratio indicates a more favorable investment decision, indicating a better reward per unit of market risk taken.
Calculating the Treynor ratio involves using a portfolio's beta measure as a measure of risk, similar to the Sharpe measure but specifically for market risk.
Differences between Sharpe, Trainor and Alpha Jensen?
The differences between Sharpe, Treynor, and Jensen alpha ratios lie mainly in risk and performance measures.
The Sharpe ratio uses the standard deviation to measure total risk, making it suitable for risk-adjusted total return analysis.
The Treynor ratio uses beta to focus on market risk, making it ideal for diversified portfolios. Jensen's Alpha evaluates an investment's ability to deliver excess returns compared to those predicted by the CAPM, highlighting the portfolio manager's performance.
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Both the Sharpe and Treynor ratios provide valuable insights into the risk-adjusted performance of investments. But the possibility of its application varies depending on the nature of the investment and the investor’s goals. Understanding these nuances can greatly enhance investment decisions.
