Risk-Adjusted Return: Examples and Formulas
Risk is an inherent part of any investment, which is why investors consider risk-adjusted returns when analyzing various investment options. But what is a risk-adjusted return?
A risk-adjusted return is a measure of return that compares the potential profit from an investment to the degree of risk that must be accepted in order to achieve it. The reference point is usually a risk-free investment, such as U.S. Treasuries. Risk-adjustment returns enable the investor to compare high-risk and low-risk investments.
In this post, we take a look at risk-adjusted returns: examples and explanations.
What is meant by risk-adjusted return?
There isn’t a clear-cut definition of risk-adjusted return. One of the reasons is that many disagree as to what is risk. However, risk is mostly about avoiding swings in the returns – volatility. But please keep in mind that for example Warren Buffett and Charlie Munger argue that volatility is a very poor form of measuring risk. Their logic is that even a sound business is not immune to volatility and might suffer temporarily.
That said, in the rest of the article we mostly use volatility as a measure of risk.
A risk-adjusted return is a measure of return that compares the potential profit from an investment to the degree of risk that must be accepted in order to achieve it. The reference point is usually a risk-free investment, such as U.S. Treasuries. Risk-adjustment returns enable the investor to compare between high-risk and low-risk investments.
The metric can be applied to individual stocks, investment funds, or an entire portfolio. There are different methods of getting a risk-adjusted return, and depending on the method used, the risk calculation can be expressed as a number or a rating.
Risk and behavioral biases
If you have an investment or trading strategy that is liable to swings in return, it might lead to two things:
- You might increase the risk of ruin, especially if you are leveraged (please read here for what is the risk of ruin in trading?).
- Swings in volatility normally leads to behavioral mistakes (behavioral mistakes and risk).
We have been trading and investing for over 20 years, and we confirm that having losses might make us do irrational things. Even when you have the best trading strategies there are, you might abandon them in the midst of a drawdown. Please read more about drawdowns and trading biases, but at the end of the day, only experience can teach you how to deal with them.
How do you calculate a risk-adjusted return? Formula
There are different ways to calculate a risk-adjusted return. Some of the popular methods are Sharpe Ratio, Treynor Ratio, and Jensen’s Alpha.
Sharpe Ratio
This measures the profit of an investment that exceeds the risk-free rate, per unit of standard deviation — a measure of the total risk in an investment. You calculate Sharpe Ratio by taking the return of the investment, subtracting the risk-free rate, and dividing the result by the investment’s total risk (standard deviation).
Where:
- Rp = Expected Portfolio Return
- Rf = Risk-free Rate
- Sigma(p) = Portfolio Beta
Generally, a higher Sharpe ratio is better, all other things being equal, but a high ratio might indicate you have a curve fitted trading strategy.
Treynor Ratio
The Treynor ratio is calculated the same way as the Sharpe ratio, but it uses the investment’s beta in the denominator. Beta is a measurement of the volatility (systematic risk) of a security or portfolio compared to the market as a whole (usually the S&P 500).
Treynor Ratio = (Rp — Rf)/βp
Where:
Just like Sharpe Ratio, a higher Treynor ratio is better.
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