What Does Risk-Adjusted Return Mean?
Risk-adjusted return refers to the financial gains or performance of an investment, taking into account the level of risk that was taken to achieve these returns. It's a concept used in finance to understand how much risk is involved in producing a specific return.
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How Is It Calculated?
Several methods can be used to calculate risk-adjusted returns, each with its own approach to considering risk:
Sharpe Ratio: This is one of the most commonly used risk-adjusted return measures. It is calculated by subtracting the risk-free rate of return (like U.S. Treasury Bonds) from the return of the investment and then dividing that result by the standard deviation of the investment’s excess return (measure of volatility).
What this means is if the investment performance has had lots of volatility, then it is more risky and will score worse. The thinking here being that you can sometimes have really good performances over short periods of time, but when you take into account risk-free rates and volatility, the return may not outweigh the risks of the investment.
Sortino Ratio: Similar to the Sharpe Ratio but only considers downside risk (negative returns), which is more relevant for investors concerned primarily with losses. It is the same calculation as the Sharpe Ratio, except you use the standard deviation of the negative asset returns (downside deviation) when calculating the denominator.
Treynor Ratio: This uses beta (a measure of volatility in relation to the market) instead of standard deviation to evaluate risk-adjusted returns. Otherwise, the rest of the calculation is the same. So all the variations just have to do with different types of denominators.
To do these calculations, you will need to have a good grasp on standard deviation or find data sources that have it already calculated for various underlying assets that you are analyzing.
Why Is It Important in Finance and Investment Analysis?
- Better Comparison of Investments: Risk-adjusted returns allow investors to compare the performance of assets with different levels of risk. It's not just about how much an investment earns, but how much it earns for each unit of risk taken.
- Informed Decision Making: Investors can make more informed decisions by understanding the risk involved in achieving certain returns. It helps in selecting investments that align with their risk tolerance and investment goals.
- Performance Evaluation: It provides a more holistic view of an investment’s performance, especially when comparing fund managers or investment strategies.
- Risk Management: Helps in managing the risk exposure of a portfolio and in achieving diversification by understanding the risk-return trade-off.
In summary, risk-adjusted returns provide a more nuanced view of an investment's performance by accounting for the risk involved, making it a crucial concept in finance and investment analysis for both individual and institutional investors.
Article found in Valuation.
