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Sharpe Ratio vs. Treynor Ratio: What’s the Difference

Anshika

Discover the difference between the Sharpe Ratio and Treynor Ratio by understanding how each measures risk-adjusted returns using distinct risk definitions.

Sharpe ratio and Treynor ratio are two popular risk-adjusted return metrics used to evaluate how efficiently an investment generates returns relative to the risks taken. Although both provide insights into performance, they differ in the type of risk considered and when each is most appropriate. Understanding these differences can help investors choose the right metric based on portfolio structure, diversification, and investment strategy.

What Is the Sharpe Ratio

The Sharpe ratio measures how much excess return an investment generates for every unit of total risk. It uses standard deviation as the risk indicator, which captures both systematic and unsystematic risk.

Sharpe ratio is useful when:

  • Evaluating portfolios with multiple assets

  • Measuring volatility-driven risk

  • Comparing diversified portfolios

  • Assessing total risk rather than only market risk

By focusing on total variability, it helps determine whether higher returns come from genuine performance or merely higher volatility.

What Is the Treynor Ratio

The Treynor ratio measures excess return earned per unit of systematic risk, represented by beta. Beta reflects how sensitive an investment is to market movements.

Treynor ratio is suitable when:

  • Evaluating well-diversified portfolios

  • Comparing investments exposed mainly to market risk

  • Understanding performance relative to benchmark volatility

  • Assessing fund managers with stock market-driven strategies

Since beta excludes unsystematic risk, the Treynor ratio is most suitable when diversifiable risks are already minimised.

Sharpe Ratio Formula & Example

The formula for Sharpe ratio is as follows:

  • Sharpe Ratio = (Portfolio Return − Risk-Free Rate) ÷ Standard Deviation

Example (simplified):

  • Portfolio return: 12%

  • Risk-free rate: 4%

  • Standard deviation: 10%

Sharpe Ratio = (12 − 4) ÷ 10 = 0.8

A higher ratio indicates improved risk-adjusted performance.

Treynor Ratio Formula & Example

The formula for Treynor ratio is as follows:

  • Treynor Ratio = (Portfolio Return − Risk-Free Rate) ÷ Beta

Example (simplified):

Treynor Ratio = (14 − 4) ÷ 1.2 ≈ 8.33

This shows how efficiently the portfolio rewards investors for market risk exposure.

Key Differences Between Sharpe and Treynor Ratios

Sharpe ratio and Treynor ratio differ in the following ways:

Aspect Sharpe Ratio Treynor Ratio

Risk measured

Total risk (standard deviation)

Systematic risk (beta)

Suitable for

Diversified or undiversified portfolios

Well-diversified portfolios

Focus

Volatility relative to returns

Market risk relative to returns

Suitable for

Comparing portfolios with different compositions

Benchmark-linked, market-sensitive portfolios

Assumes

Total risk matters

Only market risk matters

These differences highlight where each ratio can offer improved insights.

When to Use Sharpe, When to Use Treynor

Sharpe ratio is preferred when:

  • The portfolio is not fully diversified

  • Total volatility impacts performance

  • A complete risk-adjusted performance measure is provided

Treynor ratio is preferred when:

  • Evaluating diversified portfolios

  • Market risk is the only relevant factor

  • Comparing fund managers with similar strategies

The choice of ratio depends on the level of unsystematic risk in the portfolio.

Limitations of Each Ratio

Both ratios offer valuable insights but come with limitations.

Sharpe ratio limitations:

  • Sensitive to time period and return distribution

  • May misrepresent strategies with irregular or skewed returns

  • Total volatility may not always reflect actual risk

Treynor ratio limitations:

  • Relies heavily on beta, which can change over time

  • Not meaningful for undiversified portfolios

  • Assumes market risk is the only relevant risk

Understanding these constraints helps avoid misinterpretation.

Conclusion & Key Takeaways

Sharpe ratio and Treynor ratio are essential tools for risk-adjusted performance evaluation. The Sharpe ratio measures return relative to total volatility, while the Treynor ratio measures return relative to systematic risk. The choice between the two depends on portfolio diversification and the type of risk being assessed.

Points to Remember:

  • Sharpe ratio uses standard deviation to measure total risk.

  • Treynor ratio uses beta to measure market risk only.

  • Sharpe works for both diversified and undiversified portfolios.

  • Treynor is suitable for diversified portfolios with minimal unsystematic risk.

  • Both help evaluate risk-adjusted performance but must be used in the right context.

Disclaimer

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.

FAQs

What assumptions underlie these ratios?

These ratios assume that historical patterns of risk and return will remain broadly consistent and that risk can be measured reliably through indicators such as volatility or beta. The assumptions provide the basis for comparing performance across portfolios.

What is the Treynor ratio used for?

The Treynor ratio is used to evaluate how much excess return a portfolio generates relative to the level of systematic market risk it carries. The measure helps show the efficiency of returns after accounting for market-related risk exposure.

What is another name for the Sharpe ratio?

The Sharpe ratio is also known as the reward-to-variability ratio. This alternative term highlights the relationship between excess return and total return variability.

What is the alternative to the Sharpe ratio?

Alternatives to the Sharpe ratio include the Sortino ratio, the Information ratio, and the Calmar ratio. Each alternative focuses on different aspects of risk, such as downside volatility, benchmark-relative performance, or drawdown behaviour.

What is the formula for the Treynor ratio?

The Treynor ratio is calculated using the formula: Treynor Ratio = (Portfolio Return − Risk-Free Rate) ÷ Beta. The result reflects the excess return earned for each unit of systematic risk.

Hi! I’m Anshika
Financial Content Specialist

Anshika brings 7+ years of experience in stock market operations, project management, and investment banking processes. She has led cross-functional initiatives and managed the delivery of digital investment portals. Backed by industry certifications, she holds a strong foundation in financial operations. With deep expertise in capital markets, she connects strategy with execution, ensuring compliance to deliver impact. 

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