Investment management tool measuring risk-adjusted performance, quantifying returns in relation to risk taken, denoted by the formula (Portfolio Return - Risk-free Rate) / Portfolio Volatility.
The Treynor ratio is a valuable tool for investors and traders seeking to evaluate the performance of their portfolios on a risk-adjusted basis. This ratio, named after economist Jack L. Treynor, differs from other risk/return metrics, such as the Sharpe ratio, in its focus on systematic risk.
Systematic risk, also known as market risk, is the portion of a portfolio's total risk that is attributed to broad market movements. This risk is quantified by a portfolio's beta, a measure of its sensitivity to market changes. In contrast, the Sharpe ratio considers total risk, including both systematic and unsystematic risk (risks specific to individual securities within the portfolio).
The Treynor ratio formula is as follows: (Portfolio return - Risk-free rate) / Beta
This formula calculates the excess return per unit of systematic risk. The risk-free rate is typically represented by U.S. treasury bills, which provide a benchmark for risk-free returns.
The greater the Treynor ratio, the more stable a portfolio is on a risk-adjusted basis. A higher ratio indicates that the portfolio is earning a higher excess return for each unit of systematic risk taken on. Conversely, a lower ratio suggests that the portfolio is underperforming relative to the amount of systematic risk it is exposed to.
The Treynor ratio is particularly useful for well-diversified portfolios where unsystematic risk is minimized. By isolating market risk, it allows investors to compare portfolios on an even playing field, focusing on the factors that can be controlled and predicted more accurately.
In contrast, the Sharpe ratio provides a broader assessment of risk-adjusted performance, as it accounts for all volatility sources. This makes it more applicable when total risk, including unsystematic factors, is relevant.
In summary, the Treynor ratio and the Sharpe ratio serve complementary roles in helping investors understand the risk-adjusted returns of their portfolios. The Treynor ratio caters to those seeking a systematic risk perspective, while the Sharpe ratio offers a comprehensive risk evaluation. Both ratios are essential tools for informed investment decision-making.
[1] Investopedia. (2021). Treynor Ratio. Retrieved from https://www.investopedia.com/terms/t/treynorratio.asp [2] Investopedia. (2021). Sharpe Ratio. Retrieved from https://www.investopedia.com/terms/s/sharperatio.asp [3] CFA Institute. (2021). Treynor Ratio. Retrieved from https://www.cfainstitute.org/-/media/files/program/investment-management/investment-management-curriculum/2021-2022/module-1/readings/risk-management-readings/treynor-ratio.pdf [4] CFA Institute. (2021). Sharpe Ratio. Retrieved from https://www.cfainstitute.org/-/media/files/program/investment-management/investment-management-curriculum/2021-2022/module-1/readings/risk-management-readings/sharpe-ratio.pdf
['Investing and finance are relevant when discussing the Treynor ratio, as it is a tool used by investors and traders to evaluate their portfolios' performance on a risk-adjusted basis, specifically in terms of systematic risk.', 'For those looking to compare portfolios on a systematic risk perspective, the Treynor ratio might be of more interest, while the Sharpe ratio, which accounts for all volatility sources, could be a better choice when total risk, including unsystematic factors, is relevant in the context of investing and finance.']
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