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 (