Risk-adjusted returns in investing

However, simply looking at the return on investment (ROI) does not give a full picture of an investment’s effectiveness, especially when comparing assets with varying levels of risk. This is where the concept of risk-adjusted returns comes in.

Understanding Risk-Adjusted Returns

Risk-adjusted returns are metrics used to assess how much return an investment generates in relation to the risk involved in making that investment. In simpler terms, it compares how much return you are getting for the amount of risk you are taking. Different investments carry different levels of risk. For instance, stocks tend to be more volatile and risky than bonds. Therefore, an investor must assess not just the potential return but also how much risk they are taking on to achieve that return.

This measure is crucial because higher returns often come with higher risk. Without adjusting for risk, an investor might focus solely on the return without considering the underlying volatility or the chance of losing capital.

Common Measures of Risk-Adjusted Returns

Several different metrics are used to measure risk-adjusted returns, each offering a different perspective on how well an investment is performing relative to the risk taken.

Sharpe Ratio The Sharpe ratio is one of the most commonly used tools for calculating risk-adjusted returns. It is defined as the ratio of the excess return (the return above the risk-free rate, typically U.S. Treasury bills) to the standard deviation (a measure of volatility or risk) of the investment's returns. The formula is as follows:

Sharpe Ratio

=

𝑅

𝑝

−

𝑅

𝑓

𝜎

𝑝

Sharpe Ratio=

σ

p

​

R

p

​

−R

f

​

​

Where:

𝑅

𝑝

R

p

​

is the return of the portfolio

𝑅

𝑓

R

f

​

is the risk-free rate

𝜎

𝑝

σ

p

​

is the standard deviation of the portfolio's returns

A higher Sharpe ratio is considered better because it indicates a higher return for each unit of risk. If an investor’s portfolio has a Sharpe ratio of 1, it means that the returns are equal to the risk taken. A Sharpe ratio greater than 1 is generally considered good, while a ratio below 1 suggests that the risk taken is not being compensated by returns.

Sortino Ratio Similar to the Sharpe ratio, the Sortino ratio also measures risk-adjusted returns, but it only considers downside risk (negative volatility) rather than total volatility. This is important because investors are usually more concerned with the risk of losses than with overall volatility. The Sortino ratio is defined as:

Sortino Ratio

=

𝑅

𝑝

−

𝑅

𝑓

𝜎

𝑑

Sortino Ratio=

σ

d

​

R

p

​

−R

f

​

​

Where

𝜎

𝑑

σ

d

​

is the standard deviation of negative returns (downside risk). The Sortino ratio is often seen as a more precise measure of risk-adjusted returns because it focuses on the risk that affects investors most—downside risk.

Treynor Ratio The Treynor ratio is another popular metric for evaluating risk-adjusted returns, but it uses systematic risk (beta) instead of total risk (standard deviation). It is calculated as:

Treynor Ratio

=

𝑅

𝑝

−

𝑅

𝑓

𝛽

𝑝

Treynor Ratio=

β

p

​

R

p

​

−R

f

​

​

Where

𝛽

𝑝

β

p

​

represents the portfolio's beta, which measures its sensitivity to overall market movements. A higher Treynor ratio indicates that an investment is providing better returns for each unit of market risk.

Alpha Alpha is a measure of the excess return an investment has generated compared to a benchmark index (like the S&P 500). It represents the value that a portfolio manager adds or subtracts from a fund's return through their investment choices, after adjusting for the risk taken. A positive alpha indicates that the investment has outperformed the market on a risk-adjusted basis, while a negative alpha means the opposite.

Alpha is calculated as:

𝛼

=

𝑅

𝑝

−

(

𝑅

𝑓

+

𝛽

𝑝

×

(

𝑅

𝑚

−

𝑅

𝑓

)

)

α=R

p

​

−(R

f

​

+β

p

​

×(R

m

​

−R

f

​

))

Where

𝑅

𝑚

R

m

​

is the return of the market index. A positive alpha is considered a sign of superior risk-adjusted performance.

Why Risk-Adjusted Returns Matter

Risk-adjusted returns help investors evaluate whether the returns they are earning on their investments are worth the risk they are assuming. Without adjusting for risk, investors might favor higher-return investments without considering the associated risk of significant losses.

For example, if an investor is comparing two stocks, one with a 10% return and another with a 12% return, they might initially be inclined to choose the 12% stock. However, if the 12% stock is much more volatile (high risk), it may not necessarily provide better value when adjusting for risk. In contrast, a 10% return with lower volatility might provide a more stable, long-term investment option.

Practical Implications for Investors

Risk-adjusted returns help investors make informed decisions. For instance:

Portfolio Diversification: By looking at risk-adjusted returns, investors can better diversify their portfolios by selecting investments that offer the highest return for the lowest risk.

Risk Tolerance Assessment: Investors can assess their risk tolerance and choose investments that align with their personal comfort levels and financial goals.

Asset Allocation: Risk-adjusted metrics can inform decisions about how to allocate assets across different investment classes, such as stocks, bonds, and real estate.

Conclusion

Risk-adjusted returns are essential for making smarter investment decisions. Simply chasing high returns without considering risk can be dangerous, especially for long-term financial goals. Using metrics like the Sharpe ratio, Sortino ratio, Treynor ratio, and alpha, investors can better evaluate the true performance of their investments and optimize their portfolios for both risk and reward. Understanding risk-adjusted returns allows investors to achieve the right balance between risk and return, improving the likelihood of financial success over time.