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Many investors make the mistake of judging the performance of their portfolios solely based on returns. Few investors think about the risks of earning those returns. Investors have understood how to quantify and assess risk with the variability of returns since the 1960s, but no single metric looked at both risk and return at the same time. To help with portfolio reviews, there are three kinds of performance measurement tools available today. The Treynor, Sharpe, and Jensen ratios are all similar in that they aggregate risk and return performance into a single number. Which one is the most suitable? Maybe it's a combo of the three.

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Jack L. Treynor was the first to provide investors with a composite measure of portfolio performance that also included risk. His objective was to find a performance measure that could apply to all investors regardless of their personal risk preferences. He introduced the concept of the security market line, which defines the relationship between portfolio returns and market rates of returns. The greater the line's slope, the better the risk-return tradeoff.

The higher the Treynor measure, the better the portfolio.? Because this measurement primarily takes into account systematic risk, it assumes that the investor already has a well-diversified portfolio and hence ignores unsystematic risk (also known as diversifiable risk). As a result, investors with diversified portfolios will benefit the most from this performance metric.

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The Sharpe ratio is identical to the Treynor measure, except that instead of systematic risk, which is represented by beta, the risk measure is the portfolio's standard deviation. This metric, developed by Bill Sharpe, compares portfolios to the capital market line and is based on his work on the capital asset pricing model (CAPM).

The Sharpe ratio, unlike the Treynor measure, assesses the portfolio manager on both rates of return and diversity. We discovered that the best portfolio isn't always the one with the biggest return. A superior portfolio, on the other hand, has a higher risk-adjusted return.

As a result, the Sharpe ratio is better suited to well-diversified portfolios because it more correctly accounts for the portfolio's risks.

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The excess return that a portfolio achieves over its expected return is calculated using the Jensen measure of return. The Jensen ratio calculates how much of the portfolio's rate of return is due to the manager's ability to provide above-average returns when market risk is taken into account. The Jensen measure is calculated using the CAPM and is named after its developer, Michael C. Jensen. Alpha is another name for this return measure.

For each time interval, the Jensen measure requires the implementation of a variable risk-free rate of return. The Treynor and Sharpe ratios look at average returns for all variables in the calculation during a certain period (the portfolio, market, and risk-free asset).

Jensen's alpha, like the Treynor measure, evaluates risk premiums in terms of beta (systematic, undiversifiable risk) and hence presupposes that the portfolio is already well-diversified. As a result, this ratio is best applied to a mutual fund as an investment.

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