For example, a 2% annual total portfolio return may initially seem small. However, if the market only increased by 1% during the same time interval, then the portfolio performed well compared to the universe of available securities. On the other hand, if this portfolio was exclusively focused on extremely risky micro-cap stocks, the 1% additional return over the market does not properly compensate the investor for risk exposure. Based on the need to accurately measure performance, various ratios are used to determine the risk-adjusted return of an investment portfolio. We'll look at the five common ones in this article.

**Sharpe Ratio**

Many of the following ratios are similar to the Sharpe in that a measure of return over a benchmark is standardized for the inherent risk of the portfolio, but each has a slightly different flavor that investors may find useful, depending on their situation.

**Roy's Safety-First Ratio**

The investor will often specify the target return based on financial requirements to maintain a certain standard of living, or the target return can be another benchmark. In the former case, an investor may need $50,000 per year for spending purposes; the target return on a $1 million portfolio would then be 5%. In the latter scenario, the target return may be anything from the S&P 500 to annual gold performance – the investor would have to identify this target in the investment policy statement.

**Sortino Ratio**

The Sortino ratio, on the other hand, only includes the downside deviation. This means only the volatility that produces fluctuating returns below a specified benchmark is taken into consideration. Basically, only the left side of a normal distribution curve is considered as a risk indicator, so the volatility of excess positive returns are not penalized. That is, the portfolio manager's score isn't hurt by returning more than was expected.

**Treynor Ratio**

Because the Treynor ratio bases portfolio returns on market risk, rather than portfolio specific risk, it is usually combined with other ratios to give a more complete measure of performance.

**Information Ratio**

In contrast to the Sharpe, Sortino and Roy's safety-first ratios, the information ratio uses the standard deviation of active returns as a measure of risk instead of the standard deviation of the portfolio. As the portfolio manager attempts to outperform the benchmark, she will sometimes exceed that performance and at other times fall short. The portfolio deviation from the benchmark is the risk metric used to standardize the active return.

**The Bottom Line**

The above ratios essentially perform the same task: They help investors calculate the excess return per unit of risk. Differences arise when the formulas are adjusted to account for different kinds of risk and return. Beta, for example, is significantly different from tracking-error risk. It is always important to standardize returns on a risk-adjusted basis so that investors understand that portfolio managers who follow a risky strategy are not more talented in any fundamental sense than low-risk managers, they are just following a different strategy.

Another important consideration regarding these metrics is that they can only be compared to one another directly. In other words, the Sortino ratio of one portfolio manager can only be compared to the Sortino ratio of another manager. The Sortino ratio of one manager cannot be compared to the information ratio of another. Fortunately, these five metrics can all be interpreted in the same manner: The higher the ratio, the greater the risk adjusted performance.