Many investors mistakenly base the success of their portfolios on returns alone. Few consider the risk that they took to achieve those returns. 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. Today, we have three sets of performance measurement tools to assist us with our portfolio evaluations. The Treynor, Sharpe and Jensen ratios combine risk and return performance into a single value, but each is slightly different. Which one is best for you? Why should you care? Let's find out.
Treynor Measure
Jack L. Treynor was the first to provide investors with a composite measure of portfolio performance that also included risk. Treynor's objective was to find a performance measure that could apply to all investors, regardless of their personal risk preferences. 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 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). The beta coefficient is simply the volatility measure of a stock portfolio to the market itself. The greater the line's slope, the better the riskreturn tradeoff.
The Treynor measure, also known as the reward to volatility ratio, can be easily defined as:
(Portfolio Return – RiskFree Rate) / Beta 
The numerator identifies the risk premium and the denominator corresponds with the risk of the portfolio. The resulting value represents the portfolio's return per unit risk.
To better understand how this works, suppose that the 10year annual return for the S&P 500 (market portfolio) is 10%, while the average annual return on Treasury bills (a good proxy for the riskfree rate) is 5%. Then assume you are evaluating three distinct portfolio managers with the following 10year results:
Managers  Average Annual Return  Beta 
Manager A  10%  0.90 
Manager B  14%  1.03 
Manager C  15%  1.20 
Now, you can compute the Treynor value for each:
T(market) = (.10.05)/1 = .05
T(manager A) = (.10.05)/0.90 = .056
T(manager B) = (.14.05)/1.03 = .087
T(manager C) = (.15.05)/1.20 = .083
The higher the Treynor measure, the better the portfolio. 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. However, when considering the risks that each manager took to attain their respective returns, Manager B demonstrated the better outcome. In this case, all three managers performed better than the aggregate market.
Because 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. As a result, this performance measure should really only be used by investors who hold diversified portfolios.
Sharpe Ratio
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. 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 can be easily defined as:
(Portfolio Return – RiskFree Rate) / Standard Deviation 
Using the Treynor example from above, and assuming that the S&P 500 had a standard deviation of 18% over a 10year period, let's determine the Sharpe ratios for the following portfolio managers:
Manager  Annual Return  Portfolio Standard Deviation 
Manager X  14%  0.11 
Manager Y  17%  0.20 
Manager Z  19%  0.27 
S(market) = (.10.05)/.18 = .278
S(manager X) = (.14.05)/.11 = .818
S(manager Y) = (.17.05)/.20 = .600
S(manager Z) = (.19.05)/.27 = .519
Once again, we find that the best portfolio is not necessarily the one with the highest return. Instead, it's the one with the most superior riskadjusted return, or in this case the fund headed by manager X.
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). Therefore, the Sharpe ratio is more appropriate for well diversified portfolios, because it more accurately takes into account the risks of the portfolio.
Jensen Measure
Like the previous performance measures discussed, the Jensen measure is also based on CAPM. Named after its creator, Michael C. Jensen, the Jensen measure calculates the excess return that a portfolio generates over its expected return. This measure of return is also known as alpha.
The Jensen ratio measures how much of the portfolio's rate of return is attributable to the manager's ability to deliver aboveaverage returns, adjusted for market risk. The higher the ratio, the better the riskadjusted returns. A portfolio with a consistently positive excess return will have a positive alpha, while a portfolio with a consistently negative excess return will have a negative alpha
The formula is broken down as follows:
Jensen\'s Alpha = Portfolio Return – Benchmark Portfolio Return 
Where: Benchmark Return (CAPM) = RiskFree Rate of Return + Beta (Return of Market – RiskFree Rate of Return) 
So, if we once again assume a riskfree rate of 5% and a market return of 10%, what is the alpha for the following funds?
Manager  Average Annual Return  Beta 
Manager D  11%  0.90 
Manager E  15%  1.10 
Manager F  15%  1.20 
First, we calculate the portfolio's expected return:
ER(D)= .05 + 0.90 (.10.05) = .0950 or 9.5% return
ER(E)= .05 + 1.10 (.10.05) = .1050 or 10.50% return
ER(F)= .05 + 1.20 (.10.05) = .1100 or 11% return
Then, we calculate the portfolio's alpha by subtracting the expected return of the portfolio from the actual return:
Alpha D = 11% 9.5% = 1.5%
Alpha E = 15% 10.5% = 4.5%
Alpha F = 15% 11% = 4.0%
Which manager did best? Manager E did best because, although manager F had the same annual return, it was expected that manager E would yield a lower return because the portfolio's beta was significantly lower than that of portfolio F.
Of course, both rate of return and risk for securities (or portfolios) will vary by time period. The Jensen measure requires the use of a different riskfree rate of return for each time interval considered. So, let's say you wanted to evaluate the performance of a fund manager for a fiveyear period using annual intervals; you would have to also examine the fund's annual returns minus the riskfree return for each year and relate it to the annual return on the market portfolio, minus the same riskfree rate. Conversely, the Treynor and Sharpe ratios examine average returns for the total period under consideration for all variables in the formula (the portfolio, market and riskfree asset). Like the Treynor measure, however, Jensen's alpha calculates risk premiums in terms of beta (systematic, undiversifiable risk) and therefore assumes the portfolio is already adequately diversified. As a result, this ratio is best applied with diversified portfolios, like mutual funds.
The Bottom Line
Portfolio performance measures should be a key aspect of the investment decision process. These tools provide the necessary information for investors to assess how effectively their money has been invested (or may be invested). Remember, portfolio returns are only part of the story. Without evaluating riskadjusted returns, an investor cannot possibly see the whole investment picture, which may inadvertently lead to clouded investment decisions.

Investing Basics
Beta: Know The Risk
Beta says something about price risk, but how much does it say about fundamental risk factors? Find out here. 
Investing Basics
Determining Risk And The Risk Pyramid
Many investors do not understand how to determine the risk level their individual portfolios should bear. 
Investing Basics
Beta: Gauging Price Fluctuations
Learn how to properly use this measure that can help you meet your criteria for risk. 
Retirement
Financial Planning: It's About More Than Money
Determine what you need to do now to make a drastic lifestyle change later. 
Forex Education
How To Calculate Required Rate Of Return
The required rate of return is used by investors and corporations to evaluate investments. Find out how to calculate it. 
Investing
Time to Bring Active Back into a Portfolio?
While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess. 
Retirement
Two Heads Are Better Than One With Your Finances
We discuss the advantages of seeking professional help when it comes to managing our retirement account. 
Chart Advisor
Now Could Be The Time To Buy IPOs
There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy. 
Professionals
A Day in the Life of a Hedge Fund Manager
Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end. 
Entrepreneurship
Creating a Risk Management Plan for Your Small Business
Learn how a complete risk management plan can minimize or eliminate your financial exposure through insurance and prevention solutions.

Are secured personal loans better than unsecured loans?
Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >> 
Which mutual funds made money in 2008?
Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >> 
Does mutual fund manager tenure matter?
Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >> 
Why do financial advisors dislike targetdate funds?
Financial advisors dislike targetdate funds because these funds tend to charge high fees and have limited histories. It ... Read Full Answer >> 
Why are mutual funds subject to market risk?
Like all securities, mutual funds are subject to market, or systematic, risk. This is because there is no way to predict ... Read Full Answer >> 
Why have mutual funds become so popular?
Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>