Risk-Adjusted Return

What Is a Risk-Adjusted Return?

A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes into account the degree of risk that must be accepted to accomplish it. The risk is measured in comparison to that of a virtually risk-free investment — normally U.S. Treasuries.

Contingent upon the method utilized, the risk calculation is expressed as a number or a rating. Risk-adjusted returns are applied to individual stocks, investment funds, and entire portfolios.

Understanding Risk-Adjusted Return

The risk-adjusted return measures the profit your investment has made relative to the amount of risk the investment has represented throughout a given period of time. If two or more investments delivered the equivalent return over a given time period, the one that has the lowest risk will have a better risk-adjusted return.

Some common risk measures utilized in investing incorporate alpha, beta, R-squared, standard deviation, and the Sharpe ratio. While comparing two or more potential investments, an investor ought to apply a similar risk measure to every investment under consideration to get a relative performance perspective.

Different risk measurements give investors very different analytical results, so it is important to be clear on what type of risk-adjusted return is being considered.

Instances of Risk-Adjusted Return Methods

Sharpe Ratio

The Sharpe ratio measures the profit of an investment that surpasses the risk-free rate, per unit of standard deviation. It is calculated by taking the return of the investment, subtracting the risk-free rate, and partitioning this result by the investment's standard deviation.

All else equivalent, a higher Sharpe ratio is better. The standard deviation shows the volatility of an investment's returns relative to its average return, with greater standard deviations reflecting wider returns, and narrower standard deviations inferring more concentrated returns. The risk-free rate utilized is the yield on a no-risk investment, for example, a Treasury bond (T-bond), for the relevant period of time.

For instance, say Mutual Fund A returned 12% over the past year and had a standard deviation of 10%, Mutual Fund B returns 10% and had a standard deviation of 7%, and the risk-free rate over the time period was 3%. The Sharpe ratios would be calculated as follows:

Mutual Fund A: (12% - 3%)/10% = 0.9
Mutual Fund B: (10% - 3%)/7% = 1

Despite the fact that Mutual Fund A had a higher return, Mutual Fund B had a higher risk-adjusted return, meaning that it acquired per unit of total risk than Mutual Fund A.

Treynor Ratio

The Treynor ratio is calculated the same way as the Sharpe ratio, but utilizes the investment's beta in the denominator. Similarly as with the Sharpe, a higher Treynor ratio is better.

Utilizing the previous fund model, and expecting that every one of the funds has a beta of 0.75, the calculations are as per the following:

Mutual Fund A: (12% - 3%)/0.75 = 0.12
Mutual Fund B: (10% - 3%)/0.75 = 0.09

Here, Mutual Fund A has a higher Treynor ratio, meaning that the fund is earning more return per unit of systematic risk than Fund B.

Special Considerations

Risk avoidance isn't generally something to be thankful for in investing, so be wary of over-reacting to these numbers, especially in the event that the timeline being measured is short. In strong markets, a mutual fund with a lower risk than its benchmark can limit the real performance that the investor wants to see.

Beware of over-reacting to these numbers, especially assuming the timeline being measured is short. Greater risks can mean greater rewards over the long-term.

A fund that entertains more risk than its benchmark might experience better returns. In fact, it has been shown ordinarily that higher-risk mutual funds might accrue greater losses during volatile periods, but are likewise prone to outperform their benchmarks over full market cycles.

Highlights

Anyway, the purpose of risk-adjusted return is to assist investors with determining whether the risk taken was worth the expected reward.
There are several methods of risk-adjusting performance, like the Sharpe ratio and Treynor ratio, with each yielding a slightly different result.
A risk-adjusted return measures an investment's return after taking into account the degree of risk that was taken to accomplish it.