The overall performance of your portfolio is the ultimate measure of how well your𒁏 portfolio manager does their job. The five performance ratios presented below provide investors with various measurement options.

Measuring total return isn't the best way to determine whether or not your investments are being managed effectively. For a clearer picture, you must measure your portfolio's risk-adjusted return.

Accounting for risk fine-tunes the concept of return. For example, a 2% annual total return may initially seem small. Hꦗowever, 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 marke🌳t doe♔s not properly compensate the investor for risk exposure.

With that information, an investor coul༺d have a meaningful discussion of performance quality with their portfolio manager.

1. Sharpe Ratio

The 澳洲幸运5开奖号码历史查询:Sharpe ratio, also known as the reward-to-variability ratio, is perhaps 🤡the most common portfolio management metric. This is the formula:

$\frac{(\text{Expected Return}\ -\ \text{Risk Free Rate})}{\text{Portfolio Standard Deviation}}$Portfolio Standard Deviation(Expected Return − Risk Free Rate)​

The excess return of the portfolio over the risk-free rate is standardized by the standard d🌸eviation of the excess of the portfolio return.

How It Works

Hypothetically, investors🌞 should always be able to invest in government bonds and obtain a risk-ꦕfree rate of return. The Sharpe ratio determines the expected realized return over that minimum.

Within the risk-reward framework of portfolio theory, higher-risk investments should produce high returns. As a result, a high Sharpe ratio indicates superior risk-adjusted perf𓆉ormance.

Some of the ratios th🐬at follow are similar to the Sharpe in that a measure of return over a benchmark is standardized for the inherent risk of the portfolio. However, each has a slightly different approach that investors may find useful, depending on their situation.

2. Roy's Safety-First Ratio

Roy's safety-first ratio is similar to the Sharpe but introduces one subtle modification. Rather than comparing portfolio returns to th💛e risk-free r🧸ate, the portfolio's performance is compared to a target return. This is the formula:

$\frac{(\text{Expected Return}\ -\ \text{Target Return})}{\text{Portfolio Standard Deviation}}$Portfolio Standard Deviation(Expected Return − Target Return)​

How It Works

Roy's safety-first ratio is based on the 澳洲幸运5开奖号码历史查询:safety-first rule, which states that a minimum portfolio return is required and that the portfolio manager must do ev�꧋�erything they can in order to ensure this requirement is met.

An investor will often specify that their target return should be based on a🌟 certain benchmark, such as a particular financial amount that 👍allows them to maintain a certain standard of living.

In such a case, an investor may need $50,000 per year for spending purposes; the target return on a $1 million por💧tfolio would then be 5%.

If the benchmark is a specific index, the target return might be tied to the S&P 500. Or the investor might use the annual performance of gold as a target. The investor would have to identify their target in the 澳洲幸运5开奖号码历史查询:investment policy statement.

3. Sortino Ratio

The 澳洲幸运5开奖号码历史查询:Sortino ratio looks similar to the Roy's safety-first ratio. The difference is that, rather than standardizing the 澳洲幸运5开奖号码历史查询:excess return over the standard deviation, only the downside volatility 🔯is used for the calculation. This🤪 is the formula:

$\frac{(\text{Expected Return}\ -\ \text{Target Return})}{\text{Downside Standard Deviation}}$Downside Standard Deviation(Expected Return − Target Return)​

The previous two ratios penalize upward and downward variation. For example, a portfolio that produced annual returns of +15%, +80%, and +10%, would be perceived as fairl💮y risky, so the Sharpe🃏 and Roy's safety-first ratio would be adjusted downward.

How It Works

The Sortino ratio, on the other ha🐻nd, only includes the downside deviation. Th♛is means that only the volatility that produces fluctuating returns below a specified benchmark is taken into consideration.

Basically, only the left side of a 澳洲幸运5开奖号码历史查询:normal distribution curve is considered as a risk indicator, so the volatili🗹ty of excess positive returns is not penalized. That is, the portfolio manager's score isn't hurt by returning more than was expected.

4. Treynor Ratio

The Treynor ratio als♉o calculates the additional portfolio return over the risk-free rate. This is the formula:

$\frac{(\text{Expected Return}\ -\ \text{Risk Free Rate})}{\text{Portfolio Beta}}$Portfolio Beta(Expected Return − Risk Free Rate)​

How It Works

In this case, beta is used as the risk measure to standar🔯dize performance instead of standard deviation. Thus, the Treyno꧃r ratio produces a result that reflects the number of excess returns attained by a strategy per unit of systematic risk.

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

After Jack L. Treynor introduced this portfolio♌ metric, it quickly lost some of its luster to 𒅌the now more popular Sharpe ratio.

However, Treynor will definitely not be forgotten. He studied under Italian economist Franco Modigliani and was one of the original researchers whose work paved the way for the 澳洲幸运5开奖号码历史查询:capital asset pricing model.

5. Information Ratio

The 澳洲幸运5开奖号码历史查询:information ratio is slightly more complicated than the aforementioned metrics. Yet it provides a greater undꦏerstanding of the portfolio manager's stock-pic𝓰king abilities. This is the formula:

$\frac{(\text{Portfolio Return}\ -\ \text{Benchmark Return})}{\text{Tracking Error}}$Tracking Error(Portfolio Return − Benchmark Return)​

In contrast to 澳洲幸运5开奖号码历史查询:passive investment management, active management requires regular trading to outperform a benchmark. While the manager may only invest in S&P 500 com🀅panies, he may attempt to take advantage of temporary security mispricing opportunities.

The return above the benchmark is ref🀅erred to as tಌhe active return, which serves as the numerator in the above formula.

How It Works

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, they will sometimes exceed that performance and at ot༒her time🐼s fall short.

The portfolio deviation from the 澳洲幸运5开奖号码历史查询:benchmark is the risk metric used to standardize the active return.

Potential Pitfall

Problems arise when the formulas are adjusted to account for different kinds of risk and return. Beta, for example, is significantly different from 澳洲幸运5开奖号码历史查询:tracking-error risk. So you must use the same ratio when comparin๊g returns.

In other words, 𓄧the results of the Sortino ratio relating to one portfolio manager must only be compared to the Sortino ratio for another.

The Bottom Line

The five ratios presented above can help investors to calculate excess return per unit of risk and size up portfolio performance. They all can be interpreted in the same manner: The higher the ratio๊, the greater the risk-adjusted-perfor🃏mance.

Standardized risk-adjusted returns allow investors to understand that portfolio managers who follow a risky strategy are not more talented in any fundamental sense than low-risk strategꩵy managers. They are just following a different strategy.