Also known as the reward to volatility ratio sometimes, the Treynor ratio is basically a risk assessment formula. It can estimate the volatility in the market to calculate an investment’s adjusted risk value. So, this formula is usually used by investors to calculate how big the risk is for certain investments concerning the market’s volatility.
You’re probably interested in this ratio and want to find out more about it, so that’s why you clicked on this article. Therefore, the following lines have what you desire.
Treynor Ratio – Why Is It Important?
As already mentioned above, this equation has the ability to determine the risks associated with an investment. Its aim is to adjust all these investments for market volatility when it comes to comparing them based on performance rather than market factors.
As an example, there are investments that increase in value only because the market is in an unstable period. That doesn’t indicate the fact that the investment is a good one, or that the firm has a good performance, but rather that the market has ups and downs.
So, here’s where the ratio comes into play – it places all the investments on the same risk-free plan.
Moreover, this formula is similar to the Sharpe ratio’s method which assesses volatility and risk in the market, but with one exception. Meanwhile, the Treynor one uses the portfolio’s beta of the investment to measure the risk. When it compares the volatility of the stock market and the investment’s beta, investors can assess the risk associated with it.
And so, if a stock has a beta higher than one, it increases and decreases the value faster compared to stocks with a beta less than one.
Analyzing Treynor Ratio
This equation is used by analysts and investors compare the performance of different investment opportunities. It does so by dissolving the risk that comes because with the volatility component of each investment. When it cancels out the effects of the risk, an investor can compare the financial performance of investments and funds.
In order to have a better understanding, let’s take an example. Let’s say that a fund manager makes better decisions when it comes to investments, for long-term profitability. However, there’s another fund that does better than it in the short run thanks to the market ups and downs.
The Treynor formula jumps in, and it cancels out this instability of the market by showing which fund manager is better at making decisions and investments.
How Is It Calculated?
If you want to calculate the Treynor ratio, the equation operates like this:
This formula helps you understand the components, but it should actually look like this:
So, Ri stands for the return of the investment, Rf for the risk-free state of return, and B for the beta of the portfolio.
Now that you made it to the end of the article, you should be more familiar with this concept and what it includes. Moreover, you now know how the calculation is done and can do it yourself when needed.