Investing > Treynor Ratio Explained

Treynor Ratio Explained

Finding your balance is key in life—and when it comes to investing, the balance between risk and reward is a matter of financial life and death.

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Updated January 09, 2022

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Do you like doing extra work for the same pay?

No one does, as the continued labor shortage amid the Covid pandemic shows. Fortunately, we can be our own masters when it comes to trading stocks, and we can avoid the investment equivalent of extra work for no rewards—more risk without better returns.

So how do we do this, exactly? 🤔

By cleverly avoiding investments that are unreasonably volatile using a wonderful metric known as the Treynor ratio. So let’s delve deep into its mysteries and find out how it works, where it excels, and in which cases it isn’t really all that useful.

What you’ll learn
  • What is the Treynor Ratio?
  • How to Calculate the Treynor Ratio
  • What is a Stock’s Beta?
  • What is a Good Treynor Ratio?
  • How to Use the Treynor Ratio for Investing
  • Advantages and Limitations
  • Conclusion
  • Get Started With a Stock Broker

What is the Treynor Ratio (and What Does it Tell You)? ⚖️

The Treynor ratio is a metric developed by Jack Treynor, the American economist thought by many to have fundamentally changed the way we think about building a stock portfolio. It can be considered a variation of the Sharpe ratio used to determine how the return rate of an investment relates to its associated risks.

The Treynor ratio goes a step further and takes an even closer look at how much additional risk any investment brings to your portfolio. It does this by measuring how much excess return was achieved by a portfolio compared to what could have been gained with a lower-risk investment.

In layman terms, it shows you how much bang you are getting for your buck—how much additional money you are getting for the risks you are taking. For this reason, it is often also called the risk-to-volatility ratio.

How to Calculate the Treynor Ratio 🧮

The Treynor ratio uses three main elements in its equation—portfolio’s return rate, the return rate of a no-risk investment, and the so-called beta

Breaking Down the Elements 👨‍🏫

The return rate of a portfolio is rather self-explanatory, but you might have raised your eyebrows at the idea of a risk-free investment. To immediately clarify, there are no truly risk-free investments.

That being said, treasury bonds are usually used as a benchmark for this element. They are generally considered stable even though they’re relatively low-return investments. Moreover, bonds are viewed as one of the best ways to park your money in a safe place as savings accounts nowadays are seen as a great way to make sure inflation devastates your hard-earned cash.

However, when manually calculating the Treynor ratio you can choose which low-risk investment you’ll choose as a benchmark. Apart from the industry-standard bonds, you could go for certain blue-chip stocks, or maybe even a fund that follows a big index like the S&P 500 though this approach would be very uncommon and could yield incredibly unreliable results.

This means that you would go for one of the exotic low-risk investments in the equation only if you were trying to measure something very specific. There is a bit of a consensus—though far from unanimous—that you should try and compare like with like when figuring out the Treynor ratio. Apples and oranges just don’t tend to mix.

The beta is a bit more complicated so we’ll be delving into it in its whole little section. For now breathe easy as this stat of any particular stock, fund, or anything similar is very simple to find with just an internet connection—which you presumably have.

Concocting the Ratio 🧪

Just like with the beta, the Treynor ratio for most investment vehicles can be found fairly easily online. One simple and reliable way to find all of this data quickly is by using one of the many handy stock analysis software providers.

Still, as you both always benefit from deeper insight and might have specific uses in mind, it is best if you know how to calculate the Treynor ratio yourself. The formula is as follows:

Treynor ratio

It’s really as simple as that. You take the return rate of your portfolio—or other investment in some cases—subtract the rate of the risk-free investment of your choice and divide the result by the relevant beta. But wait, how do you calculate the beta? 🤔

👍🏽 Rule of thumb: The higher the Treynor ratio you get, the better. However, if the Treynor ratio of one possible investment is twice as good as that of the other one, it doesn’t necessarily mean the investment is twice as good, just better.

What is a Stock’s Beta? 📚

In many ways, calculating beta is the hard part of figuring out the Treynor ratio so let’s break this mess down.

beta

So, let’s make a quick overview. B is the Greek letter beta and stands for—you’ve guessed it—the beta we’re calculating. rp is the stock’s return with the p in the formula standing for the measured stock in general in this formula. rb is the return of the entire market with the letter b being used as it indicates the benchmark.

Cov is the covariance—not covid thankfully—and it indicates the correlation between the changes in returns of the stock compared to the market in general and the var is the variance representing the market’s spread from the overall value. Now, we’re guessing that unless you already knew how to use this formula, you aren’t much closer to figuring it out so let’s look at a concrete example.

First, you’d need to find your desired risk-free investment. Since we’ll mostly be focusing on ETFs for our example here, let’s look at the TDTF Etf, the FlexShares iBoxx 5-Year Target Duration TIPS Index Fund which focuses on 5-year US treasury bonds. 💪

Its 5-year return rate is 3.94%.

Next, you’d want to find the appropriate return rates of both the desired investment and its relevant market. Here we’ll be looking at the SPY Etf and since it is such a big index, the return of the market as a whole.

SPY’s 5-year return rate is 17.51%

The market average return for the same period seems to be 15.27% based on the S&P 500 index.

Now you’ll want to subtract the risk-free return from both of these numbers. This gives us 13.57 and 11.33 respectively.

The final step in calculating the beta is to divide the result of subtracting risk-free returns from measured stock or fund by the relevant market return minus the risk-free return. So:

(17.51-3.94)/(15.27-3.94)=13.57/11.33=1.20

This means that when using 5-year averages, the TDTF Bond Etf as a risk-free benchmark and the entire market based on the S&P 500 for comparison, the SPY ETF’s Beta is 1.20. This means that in a bull market—the likes of which we’ve been seeing a lot lately—it will gain more for any market gain, and will lose more compared to the market in case of overall bearishness. 🐻

Just remember that this calculation serves only as an example and you should probably try to pick your own parameters and do your own math—or find a program that will do it for you—whenever going into an investment.

Quick note: A beta of 1.0 indicates that the volatility mimics that of the market. A result of more than 1.0 points toward higher volatility and below 1.0 to a lower one. 0.0 is usually displayed when there isn’t enough data—that individual stock, fund, etc hasn’t been around long enough to be measured.

What is Considered a Good Treynor Ratio? 📊

Treynor ratio should generally be used when comparing multiple investment options. Since it tends to be used to measure a portfolio—especially before or after a new investment is added—you could compare it as is, and after you add, for example, Tesla stock to it.

That being said, the higher the Treynor ratio the better. So, if your portfolio calculates to a ratio of 0.57 before you make a purchase and 0.45 after, you should skip on that investment. On the other hand, if it goes from 0.57 before to 0.67 after, it is a pretty safe buy.

You should still keep in mind that this ratio only tells you if a risk is more or less worth it. It gives no indication of the exact change in worthiness. This means that a Treynor ratio of 0.50 isn’t twice as good as 0.25, just better in very general terms.

Furthermore, the Treynor ratio can be negative and in this case, the result is—woefully—useless.

How to Use the Treynor Ratio for Investing 👷‍♂️

While some have pointed out how the Covid-19 pandemic highlighted some of its flaws, the modern portfolio theory remains, well, modern, and the prime school of thought regarding successful investing. One of its main features is the emphasis on diversification.

Some might take this to mean that diversification of a portfolio is inherently good, but that simply isn’t the case. A portfolio filled with every variety of stocks possessing the coveted traits of being both high-risk and low-reward can still be a junk portfolio. It doesn’t matter that it is so very diversified.

This is where the Treynor ratio excels—it not only shines a spotlight on junk investments but also helps you choose good stocks. It is generally a pretty decent starting point when deciding what to sell and buy.

It is rather versatile—pretty much any type of security can be evaluated using it, as long as you can find a satisfactory risk-free return for the equation. You can also use it either to directly compare your potential investments on how well they compensate you for the risks you are taking—or you could compare your current portfolio to its hypothetical counterpart that has either gotten rid of some extra baggage or made a shiny new purchase.

For example, the SEC had finally given approval for some Bitcoin ETFs in October of 2021—albeit tacit—and while the market did put a halt to the craze for a short time after, they are now more than ever bound to become an increasingly huge player in the coming years. 

These funds would be a great way to profit from the crypto market without actually entering it, with a caveat—by the very nature of index funds there would be a variety in approach. Some would wager more heavily on various cryptocurrencies and some would play it safe with more emphasis on more traditional securities.

The Treynor ratio would be able to tell you which of these are safer bets than others. Which could really help you ride the often huge tidal waves of Bitcoin pricing, and which could help you better weather the gales that are also somewhat common in the crypto market.

Advantages and Limitations of the Treynor Ratio 🚧

There is something inherently user-friendly in the Treynor ratio’s core philosophy—you should be justly and abundantly compensated for any additional risk you take. This is in-and-of-itself a big plus as it focuses on an aspect of investing that is often relegated to the fine print.

Furthermore, it is fairly easy to calculate and apply—and understand once used for comparison. It isn’t exactly rocket surgery to figure out that 0.50 is a higher number than 0.30.

However, the Treynor ratio isn’t all gain, no pain. Its first big shortcoming is that it only evaluates past data without giving any predictions. It can tell you the risk-to-volatility ratio an asset had in the past. It doesn’t and it can’t guarantee it will act in the same way after you’ve bought or sold it.

Another big problem with the Treynor ratio is that its accuracy is pretty much entirely dependent on the quality of your benchmarks—and finding the right benchmarks is seldom easy and sometimes impossible. 

For example, a Treynor ratio calculated using a beta for Ethereum that was determined by comparing this crypto’s return rate to the gold market would be fairly pointless.

Lastly, the fact that this metric doesn’t really quantify its results—it tells you if something is better or worse, not by how much—only makes the issues worse. While no analysis tool should be used in isolation, the Treynor ratio truly can’t stand on its own except when the numbers you get show a blinding disparity in risk-to-reward.

Conclusion 🚩

The Treynor ratio is an excellent tool for determining a very important stat which is often relatively sidelined or obscured—the risk-to-reward ratio of any investment you are making compared to what you’d be getting with a risk-free purchase. 

Additionally, as it is both relatively easy to calculate and readily accessible online and from some of the most reputable stock brokers available, it would be silly not to utilize it. That being said, as it is a common theme with any analysis tool, it would at best be foolhardy to use it alone. We all want to know just how well-compensated we are for what we are doing, but that is far from the only important thing in life—and in investments.

Treynor Ratio: FAQs

  • What is a Bad Treynor Ratio?

    The Treynor ratio doesn’t really operate with absolute terms like good or bad. It is a tool for comparison that tells you how worth the risks you are taking when investing with a higher number being better and a lower one being worse. However, as a negative Treynor ratio gives no useful data, so this scenario could be considered a bad Treynor ratio.

  • What is a Good Treynor Ratio for a Mutual Fund?

    As the Treynor ratio is a comparison tool there is no good result per se. Generally speaking, you’d want to compare the ratios for two or more mutual funds, and the one that gives the highest number is the one with the best Treynor ratio.

  • Is the Treynor Ratio a Percentage?

    The Treynor ratio isn’t really a percentage as it isn’t giving a measurement out of 100. In fact, it generally isn’t an absolute number—you can only derive conclusions from this metric when comparing multiple Treynor ratios with the one displaying the higher number being better. This is unlike the Sharpe ratio which, while also not really being a percentage, can be considered an absolute number in that there is a standardization—the result below 1 is considered bad, and one above 3 is viewed as excellent.

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All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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