Evaluating investment portfolio performance is crucial for investors to determine if their portfolio is achieving the desired results. When assessing portfolio performance, it is important to not only look at returns but also consider risk. Simply comparing returns does not account for how much risk was taken to achieve those returns. By evaluating risk-adjusted returns, investors can get a more complete picture of true portfolio performance. There are three key metrics that are commonly used: the Treynor Ratio, Sharpe Ratio, and Jensen’s Alpha. These ratios incorporate both risk and return factors into one value, allowing for an apples-to-apples comparison of portfolio performance.
Treynor Ratio focuses on systematic risk using beta
The Treynor Ratio, also known as the reward-to-volatility ratio, relates the portfolio’s excess return over the risk-free rate to the portfolio’s beta. Beta measures the portfolio’s systematic risk relative to the market. The Treynor Ratio is calculated as (Portfolio Return – Risk-Free Rate) / Beta. The higher the Treynor Ratio, the better the risk-adjusted return performance. This metric is best suited for well-diversified portfolios where the beta captures the majority of risk.
Sharpe Ratio uses standard deviation to measure total risk
The Sharpe Ratio uses standard deviation to measure the portfolio’s total risk rather than just systematic risk. It is calculated as (Portfolio Return – Risk-Free Rate) / Standard Deviation. Again, the higher the Sharpe Ratio, the better the risk-adjusted performance. This metric incorporates both the portfolio’s returns and diversification since standard deviation reflects risk across all assets. The Sharpe Ratio is applicable to actively managed portfolios.
Jensen’s Alpha calculates excess return over expected
Jensen’s Alpha, also known as excess return, measures how much extra return the portfolio earns above the expected return based on its level of systematic risk. It is calculated as Portfolio Return – [Risk-Free Rate + Beta x (Market Return – Risk-Free Rate)]. The market return is estimated using a benchmark index. A positive and high alpha indicates the portfolio manager’s superior performance in delivering returns beyond the compensation for market risk.
Risk-adjusted metrics enable better investment decisions
By analyzing risk-adjusted returns using metrics like the Treynor Ratio, Sharpe Ratio, and Jensen’s Alpha, investors can properly evaluate investment portfolio performance. This allows them to compare portfolio managers, choose optimal asset allocation, and make more informed investment decisions aligned with their objectives and risk tolerance. Rather than merely chasing returns, investors should aim to maximize risk-adjusted portfolio performance over the long run.
Evaluating portfolio performance requires analyzing risk-adjusted returns using metrics like Treynor Ratio, Sharpe Ratio and Jensen’s Alpha. This enables better investment decisions.