What is risk-adjusted return?

Risk-adjusted return is a way to measure how much return an investment is providing relative to the risk involved. It helps investors assess if the return justifies the risk they are taking. By using risk-adjusted return metrics, investors can compare investments with different levels of risk and reward.

Why Risk-Adjusted Return Matters

Risk-adjusted return is crucial because it allows you to compare investments that have different levels of risk. A high return can be tempting, but if the risk is too high, it might not be worth it. This measure helps investors choose the best return for the lowest possible risk.

Common Measures of Risk-Adjusted Return

There are a few key ways to measure risk-adjusted return, including:

• Sharpe Ratio: Compares the return to the standard deviation (volatility) of returns. The higher the Sharpe ratio, the better the return relative to risk.
• Sortino Ratio: Similar to the Sharpe ratio but focuses only on negative price movements, which are of more concern to investors.
• Treynor Ratio: Measures return per unit of market risk (beta) and helps assess the performance of an investment relative to market volatility.

Why Risk-Adjusted Return is Important

Risk-adjusted return helps you make informed decisions by showing whether the returns are worth the risk. By using metrics like the Sharpe or Sortino ratio, you can compare different investments, balancing risk and reward to find the best options for your financial goals.

Example of Risk-Adjusted Return

Let’s consider two investments:

• Investment A: Offers a 10% return with a risk (standard deviation) of 8%.
• Investment B: Offers a 12% return with a risk (standard deviation) of 15%.

While Investment B offers a higher return, it comes with greater risk. By using risk-adjusted return measures like the Sharpe ratio, you can assess which investment offers the better return for its level of risk.

Conclusion

Risk-adjusted return is an important concept that helps investors assess whether the returns they are getting are worth the risks they are taking. By using different risk-adjusted return metrics, you can make smarter investment choices, balancing risk with reward to meet your financial goals.