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Treynor Ratio

The Treynor Ratio, also known as the reward-to-volatility ratio, is a performance metric for determining how much excess return was generated for each unit of risk taken on by a portfolio.

Excess return in this sense refers to the return earned above the return that could have been earned in a risk-free investment. Although there is no true risk-free investment, treasury bills are often used to represent the risk-free return in the Treynor ratio.

Risk in the Treynor ratio refers to systematic risk as measured by a portfolio’s beta. Beta measures the tendency of a portfolio’s return to change in response to changes in return for the overall market.

What Does the Treynor Ratio Reveal?

In essence, the Treynor ratio is a risk-adjusted measurement of return based on systematic risk. It indicates how much return an investment, such as a portfolio of stocks, a mutual fund, or an exchange-traded fund, earned for the amount of risk the investment assumed.

If a portfolio has a negative beta, however, the ratio result is not meaningful. A higher ratio result is more desirable and means that a given portfolio is likely a more suitable investment. Since the Treynor ratio is based on historical data, however, it’s important to note this does not necessarily indicate future performance, and one ratio should not be the only factor relied upon for investing decisions.

How the Treynor Ratio Works

Ultimately, the Treynor ratio attempts to measure how successful an investment is in providing compensation to investors for taking on investment risk. The Treynor ratio is reliant upon a portfolio’s beta—that is, the sensitivity of the portfolio’s returns to movements in the market—to judge risk.

The premise behind this ratio is that investors must be compensated for the risk inherent to the portfolio because diversification will not remove it.

By Investopedia.com

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