The Sharpe ratio and the Treynor ratio (both named for their creators, William Sharpe, and Jack Treynor, respectively), are two ratios utilized to measure the risk-adjusted rate of return on either an investment portfolio or an individual stock. However, they differ in their specific approaches to evaluating investment performance.
How the Sharpe Ratio Works
First developed in 1966 and revised in 1994, the Sharpe ratio aims to reveal how well an asset performs as compared to a risk-free investment. The common benchmark used to represent that risk-free investment is U.S. Treasury bills or bonds, especially the 90-day Treasury bill. The Sharpe ratio calculates either the expected or the actual return on investment for an investment portfolio (or even an individual equity investment), subtracts the risk-free investment's return, and then divides that number by the standard deviation for the investment portfolio. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.
The primary purpose of the Sharpe ratio is to determine whether you are making a significantly greater return on your investment in exchange for accepting the additional risk inherent in equity investing as compared to investing in risk-free instruments.
How the Treynor Ratio Works
Developed around the same time as the Sharpe ratio, the Treynor ratio also seeks to evaluate the risk-adjusted return of an investment portfolio, but it measures the portfolio's performance against a different benchmark. Rather than measuring a portfolio's return only against the rate of return for a risk-free investment, the Treynor ratio looks to examine how well a portfolio outperforms the equity market as a whole. It does this by substituting beta for standard deviation in the Sharpe ratio equation, with beta defined as the rate of return that is due to overall market performance.
For example, if a standard stock market index shows a 10% rate of return, that constitutes beta; an investment portfolio showing a 13% rate of return is then, by the Treynor ratio, only given credit for the extra 3% return that it generated over and above the market's overall performance. The Treynor ratio can be viewed as determining whether your investment portfolio is significantly outperforming the market's average gains.
The Bottom Line
The difference between the two metrics is that the Treynor ratio utilizes beta, or market risk, to measure volatility instead of using total risk (standard deviation) like the Sharpe ratio.