- Sharpe ratio: This measures the risk-adjusted return of a portfolio by dividing the portfolio’s average excess return over the risk-free rate per unit of total risk as measured by its standard deviation. Here, total risk is both the upside risk and the downside risk. A portfolio with a higher Sharpe ratio is better than one with a lower Sharpe ratio.
- Treynor ratio: This measures the excess return of a portfolio relative to the benchmark, such as the risk-free rate, per unit of systematic risk as measured by beta. The Treynor ratio is similar to the Sharpe ratio but uses beta instead of standard deviation to measure risk. A portfolio with a higher Treynor ratio is better than one with a lower Treynor ratio.
- Sortino ratio: This measures the performance of an investment relative to a target return while considering the downside risk. This is similar to the Sharpe ratio but focuses on downside risk instead of total risk. The Sortino ratio helps to measure the result of the effort of minimising potential losses than maximising returns. A high Sortino ratio indicates that an investment has provided high returns for a given level of downside risk. A portfolio with a higher Sortino ratio is better than one with a lower Sortino ratio.
These risk-adjusted return metrics allow investors to compare portfolios with different risk levels and determine which portfolios offer the best risk-reward trade-off. However, it’s essential to remember that different metrics may produce different results for different portfolios, and it may be helpful to use multiple metrics to compare portfolios with different risk levels. Additionally, past performance is not necessarily indicative of future performance, and hence risk-adjusted metrics should be used with a thorough understanding of a portfolio’s overall risk and return profile.
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- An introduction to S&P 500 index
- An introduction to CRSP US Total Market Index
- An introduction to CBOE Volatility Index VIX
- An introduction to risk-free bonds and risk-free rate
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