Risk-Adjusted Return

Risk-Adjusted Return refers to a measure of how much return an investment generates relative to the amount of risk taken to achieve that return. It helps investors understand the potential reward in relation to the risk associated with an investment, making it easier to compare different opportunities.

Understanding Risk-Adjusted Return

Risk-Adjusted Return accounts for volatility and other risk factors when evaluating the performance of an investment. Different investors may look for different methods to quantify this risk, depending on their investment goals.

Key Components

• Return: The gain or loss made on an investment over a specified period, typically expressed as a percentage.
• Risk: The likelihood of incurring losses or the degree of variability in investment returns. It can be quantified using various measures such as standard deviation, beta, or Value at Risk (VaR).

Common Methods to Calculate Risk-Adjusted Return

Several approaches exist to calculate risk-adjusted returns. Some widely used methods include:

• Sharpe Ratio: Measures the excess return per unit of risk (standard deviation). Formula: (Return of the portfolio – Risk-free rate) / Standard deviation of the portfolio returns.
• Treynor Ratio: Measures return per unit of systematic risk (beta). Formula: (Return of the portfolio – Risk-free rate) / Beta of the portfolio.
• Jensen’s Alpha: Represents the excess return over the expected return based on the capital asset pricing model (CAPM). Formula: Actual return – Expected return based on CAPM.

Example of Risk-Adjusted Return

Consider two investment options: Investment A and Investment B.

• Investment A has an expected return of 10% with a standard deviation of 15%.
• Investment B has an expected return of 8% with a standard deviation of 10%.
• The risk-free rate is 2%.

Calculating Sharpe Ratio

To compare these investments, we will calculate the Sharpe Ratio for both:

Investment A:

• Return = 10%
• Risk-free rate = 2%
• Standard deviation = 15%
• Sharpe Ratio = (10% – 2%) / 15% = 0.533

Investment B:

• Return = 8%
• Risk-free rate = 2%
• Standard deviation = 10%
• Sharpe Ratio = (8% – 2%) / 10% = 0.600

Comparison and Interpretation

In this example, Investment B has a higher Sharpe Ratio (0.600) compared to Investment A (0.533). This result suggests that Investment B offers a better risk-adjusted return, as it provides a higher return per unit of risk taken when compared to Investment A.

By using risk-adjusted measures like the Sharpe Ratio, investors can make more informed decisions on where to allocate their capital relative to the risks they are willing to take, effectively balancing risk and reward.