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You are considering investing in one of two stocks. Stock A has a higher Sharpe ratio...

You are considering investing in one of two stocks. Stock A has a higher Sharpe ratio than Stock B, but Stock B has a higher Treynor ratio than Stock A. What is the difference between the two ratios? Under what circumstances would you choose Stock A and under what circumstances would you choose Stock B?

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Answer #1

The difference between Sharpe and Treynor ratio is that Sharpe ratio uses total risk for its calculation while Treynor ratio uses Beta or only systematic risk. Hence, in Treynor ratio, we get a comparison with the market while in Sharpe Ratio we get an overall view of the risk.  The Sharpe ratio helps investors understand an investment's return compared to its risk while the Treynor ratio explores the excess return generated for each unit of risk in a portfolio.

We will use the Treynor ratio when we have a benchmark index in mind to judge our performance against and Sharpe Ratio when we don't have a benchmark to compare against and we want an idea of the absolute level of return and risk.

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