It adjusts for systematic risk, offering insights into the efficiency of an investment on a risk-adjusted basis. You can use the Treynor Ratio to compare the return of your stock portfolio or a stock-based mutual fund to that of the equity market benchmark. 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. Designed by economist Jack Treynor, who also created the capital asset pricing model (CAPM), the ratio is used by investors to make informed decisions regarding asset allocation and portfolio diversification. The Treynor ratio was created by American economist Jack Treynor, who also developed the Capital Asset Pricing Model (CAPM) in the 1960s.

Beta as a Risk Measure

Thus, it shows how a portfolio’s volatility correlates with that of the index, like Nifty 50 or Sensex. A beta above 1 means a fund is more volatile than the index and vice versa. This measure gauges the returns from a collection of securities’ above a risk-free rate, adjusted by the beta value. Treynor ratio should generally be used when comparing multiple investment options. Since it tends to be used to measure a portfolio—especially before or after a new investment is added—you could compare it as is, and after you add, for example, Tesla stock to it.

Difference Between the Treynor Ratio and Sharpe Ratio

As unsystematic risk is the risk that can be diversified away, according to the efficient market theory, investors should not expect to be compensated by taking on more unsystematic risk. That’s why the Treynor ratio is often considered to be theoretically more accurate. Jack Treynor provided this ratio, expanding William Sharpe’s contributions to modern portfolio theory.

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

In any case, it is important to note that for negative beta values, Treynor ratio values will not be useful. And because these values are ordinal, the significance of their instaforex review differences could not be determined as portfolios are compared. For instance, while a 0.8 Treynor ratio is better than a 0.4, it’s not automatically twice as good.

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In this example, the portfolio generated a Treynor Ratio of 6.67%, which indicates its performance relative to its exposure to systematic risk. Systematic risk, also known as market risk, is the risk inherent in the overall market or economic system. Investments that can produce higher returns with less risk or the same amount of risk as other investments are https://www.broker-review.org/ generally considered more attractive. For instance, it would not be appropriate to use the Dow 30 Index to measure the beta of a mutual fund whose portfolio consists of small-cap companies. While the Sharpe ratio measures all elements within the total portfolio risk (i.e. systematic and unsystematic), the Treynor ratio only captures the systematic component.

The Treynor Ratio is a widely used performance measure that evaluates the risk-adjusted return of an investment portfolio relative to its systematic risk. It incorporates the portfolio return, risk-free rate, and portfolio beta to provide investors with insights into the effectiveness of their investment decisions. While it has limitations and assumptions, it can be applied in various areas of finance, including portfolio management, fund evaluation, and risk-adjusted performance comparisons. Critics have pointed out its overemphasis on systematic risk, lack of suitability for non-diversified portfolios, and sensitivity to input assumptions.

  1. They are generally considered stable even though they’re relatively low-return investments.
  2. The Treynor Ratio is a widely used performance measure that evaluates the risk-adjusted return of an investment portfolio relative to its systematic risk.
  3. Next, let’s look at some examples to understand how to calculate the Treynor ratio.

Hence, if one were to invest in XYZ mutual fund, their compensation or reward for assuming one unit of risk would be Rs.9.23. Virtually every investment decision in the financial market is preceded by ratio analysis. Interpreting metrics in tandem with objectives is a crucial practice for all market participants. That’s because such ratios offer key insights into different aspects of an investment, primarily how profitable it will be. For example, a Treynor ratio calculated using a beta for Ethereum that was determined by comparing this crypto’s return rate to the gold market would be fairly pointless.

This is represented by the numerator of the equation which is the portfolio return minus by risk-free rate. Portfolio return is the portfolio actual return over the given period of time. While the risk-free rate is the rate of the return of a risk-free asset which is usually assumed to be the treasury bond of the same currency. With this Treynor ratio calculator, you can easily analyze your portfolio’s performance against systematic risk. The Treynor ratio is commonly used to analyze a portfolio’s investment performance.

Beta measures the degree of change in returns a fund exhibits in response to market volatility. If the beta value of the portfolio is high (or more than one), it is highly volatile, and vice versa. 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. 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. It has the same numerator as the Sharpe ratio, i.e. portfolio return minus risk free rate. However, Treynor ratio measures excess return with reference to the systematic risk (i.e. beta coefficient) instead of total risk (i.e. standard deviation).

The beta of the portfolio is a critical factor, and a negative beta renders the Treynor Ratio meaningless. 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. Since the formula subtracts the risk-free rate from the portfolio return and then divides the result by the beta of the portfolio — we arrive at a Treynor ratio of 4.6%. The Treynor ratio is similar to the Sharpe ratio in many aspects because both metrics attempt to measure the risk-return trade-off in portfolio management.

The Sharpe ratio helps investors understand an investment’s return compared to its risk while the Treynor ratio explores the excess return generated for each unit of risk in a portfolio. The excess return the investor earns is over and above the risk-free returns. The risk-free investment return is considered to be a treasury bill or government security. For instance, if the treasury bills have a return of 3.5% and the portfolio provides a return of 9.5%, then the excess return is 6%. However, this portfolio undertakes a certain degree of systematic risk to achieve excess returns.

Rather than measuring a portfolio’s return only against the rate of return for a risk-free investment, the Treynor ratio looks to examine how well a portfolio outperforms the equity market as a whole. It does this by substituting beta for standard deviation in the Sharpe ratio equation, with beta defined as the rate of return due to overall market performance. The beta coefficient is the volatility measure of a stock portfolio to the market itself. The Treynor, Sharpe, and Jensen ratios combine risk and return performance into a single value to measure portfolio performance. Historically, many investors mistakenly based the success of their portfolios on returns alone. A higher Treynor ratio indicates better risk-adjusted performance, as it suggests that the portfolio generates higher returns for each unit of systematic risk compared to the market.

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