Therefore, the Sharpe ratio is more appropriate for well diversified portfolios, because it more accurately takes into account the risks of the portfolio. ![]() Unlike the Treynor measure, the Sharpe ratio evaluates the portfolio manager on the basis of both rate of return and diversification (as it considers total portfolio risk as measured by standard deviation in its denominator). Instead, it's the one with the most superior risk-adjusted return, or in this case the fund headed by manager X. ![]() Once again, we find that the best portfolio is not necessarily the one with the highest return. The Sharpe ratio can be easily defined as: Conceived by Bill Sharpe, this measure closely follows his work on the capital asset pricing model (CAPM) and by extension uses total risk to compare portfolios to the capital market line. The Sharpe ratio is almost identical to the Treynor measure, except that the risk measure is the standard deviation of the portfolio instead of considering only the systematic risk, as represented by beta. As a result, this performance measure should really only be used by investors who hold diversified portfolios. In this case, all three managers performed better than the aggregate market.īecause this measure only uses systematic risk, it assumes that the investor already has an adequately diversified portfolio and, therefore, unsystematic risk (also known as diversifiable risk) is not considered. However, when considering the risks that each manager took to attain their respective returns, Manager B demonstrated the better outcome. If you had been evaluating the portfolio manager (or portfolio) on performance alone, you may have inadvertently identified manager C as having yielded the best results. ![]() The higher the Treynor measure, the better the portfolio. Now, you can compute the Treynor value for each: The Treynor measure, also known as the reward to volatility ratio, can be easily defined as: The greater the line's slope, the better the risk-return tradeoff. The beta coefficient is simply the volatility measure of a stock portfolio to the market itself. Treynor introduced the concept of the security market line, which defines the relationship between portfolio returns and market rates of returns, whereby the slope of the line measures the relative volatility between the portfolio and the market (as represented by beta). He suggested that there were really two components of risk: the risk produced by fluctuations in the market and the risk arising from the fluctuations of individual securities. Treynor's objective was to find a performance measure that could apply to all investors, regardless of their personal risk preferences. Treynor was the first to provide investors with a composite measure of portfolio performance that also included risk. ![]() Which one is best for you? Why should you care? Let's find out. The Treynor, Sharpe and Jensen ratios combine risk and return performance into a single value, but each is slightly different. Today, we have three sets of performance measurement tools to assist us with our portfolio evaluations. Since the 1960s, investors have known how to quantify and measure risk with the variability of returns, but no single measure actually looked at both risk and return together. Few consider the risk that they took to achieve those returns. Many investors mistakenly base the success of their portfolios on returns alone.
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