Assessment of risk is important for any investor, no matter they are new or experienced. The main goal of investors is to earn maximum returns and protect their capital. For this purpose, analyzing the risk involved becomes important. This is where Sharpe and Treynor’s ratios come into play. They identify the degree of risk involved in the portfolio. But are they both used for the same purpose?
Let us find out. This article will help you understand the meaning of both the ratio, calculation, and which one is trusted more by investors.
What is the Sharpe Ratio?
A common tool used by investors to assess how well an investment’s return offsets its risk is the Sharpe Ratio, which was created by Nobel laureate William F. Sharpe. By examining the standard deviation of returns, it takes into account overall risk, which includes both market-related and asset-specific risk. It indicates the additional return you receive for every unit of total risk.
Key Features:
- Calculates the return adjusted for risk.
- Considers the volatility of the entire portfolio.
- Appropriate for all investments, regardless of how diversified they are.
- Facilitates performance comparisons between various asset classes.
Calculation:
Sharpe Ratio = Rp−Rf/ σ
Where,
- Rp = Portfolio return
- Rf = Risk-free rate
- σ = Standard deviation (total risk)
Assume a mutual fund has an annual return of 12%, a standard deviation of 10%, and a risk-free rate of 4%.
Sharpe Ratio = 12 – 4 / 10 = 0.8
Interpretation: For every 1% of risk assumed, the investor receives an excess return of 0.8%.
What is the Treynor Ratio?
Another indicator of risk-adjusted return is the Treynor Ratio, which was first presented by Jack Treynor. It only takes into account systematic risk, or the portion of risk associated with general market movements, in contrast to the Sharpe Ratio. When assessing well-diversified portfolios that have reduced particular (unsystematic) risks, this ratio is particularly helpful.
Key Features:
- Only considers market risk (beta).
- Perfect for contrasting diverse portfolios.
- Demonstrates how well a portfolio makes use of market exposure.
- Based on the reasoning of the Capital Asset Pricing Model (CAPM).
Calculation:
Treynor ratio = Rp−Rf / β
Where,
- Rp = Portfolio return
- Rf = Risk-free rate
- β = Beta (systematic risk of the portfolio)
The risk-free rate is 5%, the portfolio beta is 1.25, and the portfolio yields a 15% return.
Treynor ratio = 15 – 5 / 1.25 = 8
Interpretation: For every unit of market risk, the portfolio generates an excess return of 8%.
Comparison: Sharpe vs Treynor Ratio
Although they have different uses, the Treynor and Sharpe ratios are both useful. Investors can select the best option based on their investment objectives and portfolio structure by being aware of their differences.
| Aspect | Sharpe Ratio | Treynor Ratio |
| Risk measured | Total risk (standard deviation) | Market risk only (beta) |
| Use case | Any portfolio | Diversified portfolios |
| Ideal for | Retail investors | Institutional or fund managers |
| Risk sensitivity | Includes all types of risk | Ignores unsystematic risk |
| Diversification | Works regardless of diversification | Requires proper diversification |
Use Cases:
The Sharpe Ratio works best when
- You own a simple or undiversified portfolio as a retail investor.
- Assessing individual securities, ETFs, or mutual funds.
- You want to know how much money is made for each unit of total risk.
The Treynor Ratio works best when
- You oversee or assess a diverse portfolio.
- Contrasting several portfolios that are all subject to market risk.
- The returns produced per unit of market risk (beta) are your main concern.
Which Do Investors Trust More?
- The Sharpe Ratio is widely used by both retail and professional investors, as it offers a straightforward way to compare return per unit of total risk for any portfolio.
- The Treynor Ratio is preferred primarily when evaluating diversified portfolios, especially by professional investors and institutions, since it isolates performance per unit of systematic (market) risk. Both ratios may be used by professionals depending on the portfolio characteristics and the context.
Bottomline
The conclusion is that both the Sharpe and Treynor ratios are important for assessing the risk-return profile of portfolios. The Sharpe Ratio measures excess return per unit of total (overall) risk, making it applicable to all portfolios, diversified or not. The Treynor Ratio focuses on excess return per unit of systematic (market) risk and is most relevant when evaluating well-diversified portfolios.
Both new and professional investors may use the Sharpe Ratio, while the Treynor Ratio is commonly used by professionals when comparing diversified strategies or portfolios.
