Risk-Adjusted Rate of Return
Understanding an investment’s risk-adjusted return is essential for evaluating whether the returns justify the risks taken. In simple terms, it helps investors determine how much “bang for the buck” they are truly getting.
What Does It Measure?
It measures how much an investment has returned in relation to the level of risk assumed to achieve that return.
Why Is It Important?
Relying solely on historical average returns can be misleading and may not accurately indicate future performance. Risk-adjusted return, on the other hand, provides a more reliable benchmark for comparing investments.
By using this approach, investors can compare:
- A high-risk, high-return investment vs.
- A low-risk, modest-return investment.
This comparison answers a critical question: Is the reward worth the risk?
It also reveals whether portfolio performance reflects smart investment decisions or merely the assumption of excessive risk. For this reason, risk-adjusted returns are particularly valuable when evaluating the performance of professional money managers.
How It Works in Practice
- Investment’s actual return
- Risk-free return (often proxied by the performance of a 90-day U.S. Treasury bill over 36 months)
- Market performance and its standard deviation
Common Risk-Adjusted Return Measures
- Definition: Measures the excess return per unit of volatility.
- Formula: Sharpe Ratio = Portfolio Return - Risk-Free Return / Standard Deviation of Portfolio Returns
- Interpretation: A higher Sharpe ratio indicates superior risk-adjusted performance.
- Investment A: 54% return, Sharpe ratio = 0.279
- Investment B: 26% return, Sharpe ratio = 0.910
- Definition: Similar to Sharpe, but uses beta (systematic risk) instead of standard deviation.
- Formula: Treynor Ratio = Portfolio Return - Risk-Free Return / Portfolio Beta
- Key Point: Beta measures an investment’s sensitivity to market movements. A higher beta implies higher volatility.
- Definition: Evaluates whether portfolio returns outperform what is expected given its risk level relative to the market.
- Formula: Jensen’s Alpha = Portfolio Return - Risk-Free Return - (Portfolio Beta × (Benchmark Return - Risk-Free Return))
- Use: Often applied to assess money managers’ skill compared to a benchmark index.
- Definition: Focuses only on downside risk instead of overall volatility.
- Note: Calculation is more complex but offers a sharper view of potential downside protection.
Tricks of the Trade
- No universal benchmarks: Ratios are only meaningful when compared with similar investments.
- Use multiple measures: No single metric is perfect combining them gives a more balanced picture.
- Beware of momentum-driven returns: High Sharpe ratios during booming markets (e.g., tech stocks in 1999) may reflect overall market momentum rather than true risk management.
- Wide applicability: These measures can rank the risk-adjusted performance of individual stocks, mutual funds, and portfolios with comparable objectives.
FAQ's
What is the best measure of risk-adjusted return?
There is no single “best” measure. Sharpe ratio is most common, but Treynor, Jensen’s Alpha, and Sortino ratios are equally important depending on the investor’s focus.
Why is risk-adjusted return better than average return?
Because it considers the risk taken to achieve returns, making it a more accurate indicator of performance.
How do beginners use risk-adjusted return?
Start with the Sharpe ratio it’s easy to calculate and widely used for comparing mutual funds and portfolios.
Can risk-adjusted return predict future performance?
Not exactly. It mainly evaluates past performance, but helps identify whether returns came from good management or excess risk-taking.
Which ratio focuses on downside risk only?
The Sortino ratio measures returns relative to downside volatility, making it ideal for conservative investors.
