Which measure is most appropriate?

Because different risk adjustment measures can give different implications about a portfolio’s performance, it is important that you choose the appropriate measuring tool for your particular portfolio.

Generally, if a portfolio represents an individual’s entire investments, or if there are few financial assets in the portfolio, the Sharpe measure is considered the best measurement option by many academics and practitioners. Use the Sharpe measure if you are concerned with the overall variability of the portfolio (Zvi Bodie, Alex Kane, Alan Marcus,  Essentials of Investment, 6^th Edition, McGraw-Hill Irwin, New York, 2007, p. 579).  Remember, the portfolio’s Sharpe measure must be compared to the market’s Sharpe measure to show performance.

If your portfolio comprises many different assets and asset classes, or if you are only evaluating a portion of your portfolio, most recommend that you use the Jensen or the Treynor measure. If your portfolio is well diversified, your main concern will generally be non-diversifiable risk (the risk you cannot diversify away through owning more assets). Of these two measures, the Treynor measure is more complete because it adjusts for non-diversifiable risk. (Ibid).

There are limitations to the usefulness of risk-adjustment measures. The assumptions that underlie these measures limit their usefulness. It is important for you to understand these assumptions. For example, these measures assume that a portfolio is basically stable: however, when the portfolio is being actively managed, basic stability requirements for some statistical measures are not met. Risk-adjustment measures should be used with caution.

In addition to using risk-adjustment measures, investors should measure performance by comparing their portfolios with portfolio benchmarks as well as comparing their portfolios with the portfolios of other investors in the same investment-objective category.