To assess a stock's risk-adjusted return, you need to consider both its return and the level of risk taken to achieve that return. The most common method for calculating risk-adjusted return is using the Sharpe Ratio, which measures the excess return (the return above the risk-free rate) per unit of risk (volatility). A higher Sharpe Ratio indicates better risk-adjusted performance. You can also use other metrics like the Treynor Ratio or the Sortino Ratio, depending on your investment goals and preferences.

What is Risk-Adjusted Return?

Risk-adjusted return is a measure that evaluates how much return an investment has generated relative to the risk it has taken on. It allows investors to compare the potential returns of different investments while factoring in the risk involved. A higher risk-adjusted return means the investment is offering better returns for the amount of risk you are assuming.

How to Calculate the Sharpe Ratio?

The Sharpe Ratio is one of the most commonly used methods to assess risk-adjusted returns. It is calculated as follows:

Sharpe Ratio = (Return of the Stock - Risk-Free Rate) / Standard Deviation of the Stock

A higher Sharpe ratio means the investment is providing more return for the amount of risk taken. A Sharpe ratio greater than 1 is generally considered good, while anything above 2 is excellent.

What Is the Treynor Ratio?

The Treynor Ratio is another risk-adjusted return metric, similar to the Sharpe Ratio but with a key difference. While the Sharpe Ratio uses total risk (standard deviation), the Treynor Ratio uses systematic risk (beta), which is the risk that cannot be diversified. The Treynor Ratio is calculated as:

Treynor Ratio = (Return of the Stock - Risk-Free Rate) / Beta of the Stock

A higher Treynor ratio indicates that the stock is generating a good return relative to the amount of systematic risk taken.

What Is the Sortino Ratio?

The Sortino Ratio is a variation of the Sharpe Ratio that only considers downside risk (the risk of losing money) rather than total risk. This is because investors are more concerned about the potential for loss than for volatility in general. It is calculated as follows:

Sortino Ratio = (Return of the Stock - Risk-Free Rate) / Downside Deviation

A higher Sortino ratio indicates better performance relative to the downside risk, making it especially useful for investors looking to minimize losses.

Why Is Risk-Adjusted Return Important?

Risk-adjusted return is crucial because it helps you understand how much return you are getting for the amount of risk you are taking. Investing in a stock with a high return but high risk might not always be the best choice. Risk-adjusted return allows you to compare investments that may have different risk levels, helping you make more informed decisions and balance risk with reward effectively.