Treynor ratio, also called the Treynor index, is a measure of possible excess returns on investment if more market risk is assumed. Another name, the reward-to-volatility ratio, is perhaps a more meaningful term. The ratio was developed by Jack Treynor, the president of Treynor Capital Management, Inc., in Palos Verdes Estates, California.
The formula for the Treynor Ratio is the difference of the average return of a portfolio and the average return of a risk-free rate, divided by the beta of the portfolio or
(average portfolio return -- average return of risk-free rate) / portfolio beta
The beta of the portfolio is a measure of the volatility of a given investment measured against the overall market. It usually measures the performance of the portfolio in the last five years as the market index (usually the Standard & Poor's 500) moved up or down by 1 percent. A beta below a value of one is less volatile.
Assume a portfolio return rate of 12 percent, a risk-free rate of 2 percent and a portfolio beta of 1.2, and assign a variable to each number needed to do the calculation:
Return rate of portfolio = A = 12 Risk-free rate = B = 2 Beta of portfolio = C = 1.2
Substitute the numbers in the equation:
(A -- B) / C = (12 -- 2) / 1.2
Solve the equation:
(12 -- 2) / 1.2 = 10 / 1.2 = 8.3 (rounded)
Compare the ratio (index) against other portfolios.
A single Treynor ratio does not mean anything. It is used to compare the risk of investments. The higher the ratio or index, the higher the risk.
Understanding how the stock market and investments work is a complex undertaking. The example above is to illustrate the calculation only and is not intended to be a substitute for sound financial advice. It is always best to work with a professional consultant who can help you understand which investments and funds are best for your goals.