Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ====== Treynor Ratio ====== The Treynor Ratio (also known as the "reward-to-volatility ratio") is a performance metric that measures the returns earned in excess of what could have been earned on a risk-free investment, per unit of market risk. Developed by American economist [[Jack Treynor]], one of the minds behind the [[Capital Asset Pricing Model (CAPM)]], this ratio helps investors assess how effectively their investment [[portfolio]] is compensating them for the specific risk they take by being in the market. Unlike other metrics that look at total risk, the Treynor Ratio hones in on [[systematic risk]]—the kind of risk that can't be eliminated through [[diversification]], such as recessions or shifts in interest rates. Essentially, it answers the question: "For every unit of unavoidable market risk I took on, how much extra return did I get?" A higher Treynor Ratio suggests a better performance on a risk-adjusted basis. ===== How Does It Work? ===== At its core, the ratio is a simple comparison of reward versus a specific type of risk. It’s most useful when you assume an investor has already built a well-diversified portfolio and wants to evaluate how a particular fund or stock contributes to it. ==== The Formula Unpacked ==== The calculation looks like this: **Treynor Ratio = ([[Portfolio]] Return – [[Risk-Free Rate]]) / Portfolio [[Beta]]** Let’s break down the ingredients: * **Portfolio Return (Rp):** This is straightforward—it’s the percentage return your investment or portfolio has generated over a specific period. * **Risk-Free Rate (Rf):** This represents the return you could get from an investment with theoretically zero risk. In practice, the yield on short-term government debt, like [[U.S. Treasury Bills]], is often used as a proxy for the risk-free rate. The figure (Portfolio Return - Risk-Free Rate) is known as the [[excess return]]. * **Portfolio Beta (βp):** This is the secret sauce. //Beta measures how sensitive an asset's price is to overall market movements//. - A Beta of 1.0 means the asset moves in line with the market. - A Beta greater than 1.0 means it’s more volatile than the market. - A Beta less than 1.0 means it’s less volatile. - Importantly, Beta only captures [[market risk]] (systematic risk), not the risks specific to a single company (unsystematic risk). ==== Interpreting the Number ==== Simply put, **the higher, the better**. A higher Treynor Ratio means you're getting more return for the market risk you’re shouldering. Let’s imagine you’re comparing two mutual funds over the last year, and the risk-free rate was 2%: * **Fund Alpha:** Generated a 12% return with a Beta of 1.2. * **Fund Omega:** Generated a 10% return with a Beta of 0.8. Which one was the more efficient investment? - **Fund Alpha's Treynor Ratio:** (12% - 2%) / 1.2 = 10 / 1.2 = **8.33** - **Fund Omega's Treynor Ratio:** (10% - 2%) / 0.8 = 8 / 0.8 = **10.0** Even though Fund Alpha delivered a higher absolute return, Fund Omega was the superior choice on a risk-adjusted basis. It generated more excess return for each unit of market risk it exposed investors to. ===== The Treynor Ratio vs. The Sharpe Ratio ===== The Treynor Ratio often gets compared to its famous cousin, the [[Sharpe Ratio]]. They both measure risk-adjusted return, but they have a crucial difference in what they define as "risk." * **Treynor Ratio uses Beta:** It only considers systematic risk. This makes it ideal for evaluating how a //single stock or fund fits into an already diversified portfolio//. Why? Because if your portfolio is truly diversified, you've already minimized the company-specific risks, and the main risk you have left is the broad market risk that Beta measures. * **Sharpe Ratio uses Standard Deviation:** It considers total risk ([[volatility]]), which includes both systematic and unsystematic risk. This makes it better for evaluating the //performance of an entire portfolio or a standalone, non-diversified asset//. Think of it this way: The Sharpe Ratio is like a doctor giving a full physical exam (total risk), while the Treynor Ratio is like a cardiologist checking just your heart health (systematic risk) because you've assured them everything else is in perfect shape (diversified). ===== A Value Investor's Perspective ===== So, is the Treynor Ratio a value investor's best friend? Not exactly. While it's a clever tool, proponents of a [[Benjamin Graham]] or [[Warren Buffett]]-style approach would urge caution. The main point of friction is **Beta**. Value investors define risk very differently. To them, risk is not short-term price [[volatility]]; it's the **[[permanent loss of capital]]**. A wonderful business bought at a bargain price might see its stock swing wildly for a year (high Beta), but a patient investor faces very little //real// risk. Conversely, a stable, low-Beta company can be an extraordinarily risky investment if you buy it at an astronomical price far above its [[intrinsic value]]. The Treynor Ratio can penalize a brilliant manager who buys out-of-favor, temporarily volatile assets that are fundamentally cheap, while rewarding a manager who buys stable but dangerously overpriced stocks. For the value investor, the Treynor Ratio is a piece of the puzzle, not the whole picture. It can be useful for comparing fund managers who play the market's game. But it should never replace the fundamental analysis of a business and the critical importance of buying with a //margin of safety//. After all, the ultimate measure of risk isn't a Greek letter—it's the price you pay.