A risk-adjusted return is a metric that evaluates an investment’s profit or potential profit while considering the level of risk undertaken to achieve it. The risk is typically measured against a virtually risk-free investment, such as U.S. Treasuries.
Depending on the chosen methodology, the risk is expressed as either a number or a rating. This important metric is applicable to individual stocks, investment funds, and even entire portfolios.
Key Takeaways
- Balanced Analysis: A risk-adjusted return measures an investment’s returns, accounting for the level of risk required to achieve those returns.
- Multiple Methods: Evaluating risk-adjusted performance can be achieved through various methods such as the Sharpe and Treynor ratios, alpha, beta, and standard deviation. Each method offers a unique analytical perspective.
- Informed Decisions: Investors utilize risk-adjusted returns to determine if the potential reward justifies the accepted level of risk.
Understanding Risk-Adjusted Return
Risk-adjusted returns measure how much profit your investment has generated relative to the level of risk it has faced over a specific period. If multiple investments yield the same return, the one with the lower risk has a superior risk-adjusted return. Analysts often use MAR ratios to compare the performance of trading strategies, hedge funds, and trading advisors.
Common risk measures in investing include alpha, beta, R-squared, standard deviation, and the Sharpe ratio. When comparing investments, it’s crucial to apply the same risk measure to each asset for a balanced comparison. Different measurements can lead to varied analytical results, so clarity on which risk-adjusted return method you’re considering is essential.
Examples of Risk-Adjusted Return Methods
Here are some of the most commonly used risk-adjusted return measurements:
Sharpe Ratio
The Sharpe ratio measures the profit of an investment that exceeds the risk-free rate per unit of standard deviation. The formula is:
Sharpe Ratio = (Return of Investment - Risk-Free Rate) / Standard Deviation
A higher Sharpe ratio indicates a better risk-adjusted return. The risk-free rate used is typically the yield on a 10-year Treasury bond.
For example, if Mutual Fund A returns 12% with a standard deviation of 10%, and Mutual Fund B returns 10% with a standard deviation of 7%, with a risk-free rate of 3%, the Sharpe ratios are calculated as follows:
- Mutual Fund A: (12% - 3%) / 10% = 0.9
- Mutual Fund B: (10% - 3%) / 7% = 1
Even though Mutual Fund A has a higher return, Mutual Fund B has a better risk-adjusted return.
Treynor Ratio
The Treynor Ratio is similar to the Sharpe ratio but uses the investment’s beta in the denominator. The formula is:
Treynor Ratio = (Return of Investment - Risk-Free Rate) / Beta
Using our previous example, and assuming each fund has a beta of 0.75, the calculations become:
- Mutual Fund A: (12% - 3%) / 0.75 = 12
- Mutual Fund B: (10% - 3%) / 0.75 = 9
Here, Mutual Fund A provides a higher Treynor ratio, implying that it delivers a better return per unit of systematic risk.
Other Risk Adjustment Measures
Several other popular risk-adjusted measurements include:
- Alpha: The return generated by an investment relative to a benchmark.
- Beta: The volatility of an investment in relation to the overall market; a beta of more than one indicates greater fluctuation than the market.
- Standard Deviation: Reflects the volatility of an investment’s returns compared to its average return.
- R-squared: Describes the percentage of an investment’s performance that can be explained by the performance of a benchmark index.
Special Considerations
Being overly risk-averse isn’t always the best strategy. In a strong market, a mutual fund with lower risk than its benchmark may underperform in delivering desired returns. Funds that accept more risk may yield better returns over a complete market cycle, even though they might also experience more significant losses during volatile periods.
Frequently Asked Questions
What Are the 4 Major Risk-Adjusted Return Measures?
The most popular methods to assess risk-adjusted returns are the Sharpe ratio, alpha, beta, and standard deviation.
Is the Sharpe Ratio Synonymous with Risk-Adjusted Return?
The Sharpe ratio is one of several methods to measure an asset’s risk-adjusted return.
How Do You Calculate Risk-Adjusted Return for Real Estate?
To calculate risk-adjusted returns for real estate, you need the property’s average return and standard deviation. You can employ the 10-year Treasury rate to determine the property’s risk-adjusted return consistent with the Sharpe ratio.
Conclusion
Risk-adjusted return metrics are crucial tools for analysts to gauge the amount of risk associated with an asset relative to a known low-risk benchmark. While the 10-year Treasury often serves as the risk-free rate benchmark, various methods can measure risk. Understanding these different metrics helps you manage and optimize your portfolio more effectively.
Related Terms: investment return, risk measurement, Sharpe Ratio, Treynor Ratio, alpha, beta, standard deviation.
