What is a risk-adjusted return?

In investing, it’s important not just to look at returns but also to assess how much risk was taken to achieve those returns. This is where risk-adjusted return comes in. It is a measure that allows investors to assess the return of an investment relative to the risk taken. Risk-adjusted return provides a clearer picture of an investment’s performance, especially when comparing multiple investments with different risk profiles.

1. What is Risk-Adjusted Return?

Risk-adjusted return measures the return of an investment after considering the amount of risk involved in producing that return. Higher risk investments should, in theory, produce higher returns to compensate for the additional risk taken. Risk-adjusted return is useful because it allows investors to compare investments that have different levels of risk.

2. Common Risk-Adjusted Return Metrics

There are several commonly used metrics to calculate risk-adjusted returns. Some of the most popular ones include:

• Sharpe Ratio: This ratio is one of the most widely used measures of risk-adjusted return. It is calculated by subtracting the risk-free rate from the return of the investment and then dividing by the investment's standard deviation (volatility). A higher Sharpe ratio indicates a more favorable risk-adjusted return.
• Treynor Ratio: Similar to the Sharpe ratio, the Treynor ratio measures risk-adjusted return but uses beta (the asset's volatility relative to the overall market) rather than standard deviation. This ratio is ideal for assessing the risk-adjusted return of a portfolio relative to the overall market.
• Sortino Ratio: The Sortino ratio is a variation of the Sharpe ratio, but it only considers downside risk (negative volatility), rather than total volatility. This is useful for investors who are more concerned with losses than with overall risk.
• Alpha: Alpha measures the performance of an investment relative to a market index or benchmark. A positive alpha indicates that the investment has outperformed the benchmark after adjusting for risk.

3. How to Calculate Risk-Adjusted Return

To calculate risk-adjusted return, you need to consider both the return of the investment and the risk involved. Here is how you can calculate it using the most common metric, the Sharpe ratio:

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

For example, if your investment returns 12% over a year, the risk-free rate is 2%, and the standard deviation (volatility) is 10%, the Sharpe ratio would be:

Sharpe Ratio = (12% - 2%) / 10% = 1.0

A Sharpe ratio of 1.0 means that the investment generated returns that were one standard deviation above the risk-free rate, which is considered acceptable. The higher the Sharpe ratio, the better the investment’s risk-adjusted performance.

4. Why is Risk-Adjusted Return Important?

Risk-adjusted return is a crucial metric because it helps investors determine whether an investment's return justifies the level of risk involved. It allows for better comparisons between different investments, especially those with different risk profiles. Without risk-adjusted return, an investor might choose an investment that provides high returns but also carries a significant amount of risk, which may not align with their investment objectives.

5. How to Use Risk-Adjusted Return in Portfolio Management

When managing a portfolio, it’s important to not only look at the returns but also consider the risk taken to achieve those returns. Investors can use risk-adjusted return to:

• Compare different investment opportunities with varying risk levels
• Make more informed decisions about asset allocation
• Assess whether the potential returns from an asset justify the risks
• Optimize the portfolio for the best possible risk-return trade-off

By considering risk-adjusted returns, investors can aim for the best performance relative to the level of risk they are willing to take on. This is particularly helpful when constructing a diversified portfolio, as it ensures that the risks are spread out and mitigated across different assets.