Definition
The Risk Adjusted Return is a financial measure that quantifies the profit made from an investment against the level of risk associated with it. It helps investors to identify and compare the potential returns of different investments by assessing the level of risk involved. Higher Risk Adjusted Returns indicate better investment decisions, as they suggest more return has been gained for each unit of risk taken.
Key Takeaways
- Risk Adjusted Return accounts for the degree of risk associated with an investment. It provides a clearer view of return by taking into consideration the volatility and potential for financial loss, which standard return on investment analysis may not fully factor in.
- It helps in the comparison of the returns of two or more different investments with different risk profiles. An investment may appear more lucrative based on the raw returns, but once adjusted for risk, the one with lower returns may be the better choice.
- The most common methods to calculate Risk Adjusted Return include the Sharpe Ratio, Sortino Ratio, and Treynor Ratio. These ratios measure the performance of an investment compared to a risk-free asset, after adjusting for its risk. A higher ratio usually indicates a favorable risk-adjusted return.
Importance
The finance term, Risk Adjusted Return, is important as it provides a more comprehensive measure of investment returns by considering the risk associated with those returns.
Rather than just evaluating the return on an investment in isolation, this metric assesses the return relative to the amount of risk taken to achieve it.
It allows investors to compare the performance of different investments with varying levels of risk and helps them ensure that they are being sufficiently compensated for taking on additional risk.
Essentially, the Risk Adjusted Return helps to establish a more fair and accurate benchmark for investment performance, enabling more insightful and informed investment decisions.
Explanation
The purpose of Risk-Adjusted Return is to measure how much risk is involved in producing a particular return. This measurement provides a way to compare the performance of different investments, by taking into consideration not only the potential return but also the risk involved.
It helps to identify whether the returns of a particular investment are due to smart investing or the result of excessive risk. By giving more nuanced information about investments’ returns, investors can make more informed decisions about where to put their money.
Risk-Adjusted Return is used as a more precise gauge for the success of an investment compared to simple return calculations. For instance, an investment that has a high return may seem lucrative at first glance.
However, when using a risk-adjusted return calculation, we may find that the investment’s high return doesn’t outweigh the risk it carries, and is therefore not as attractive as it seemed initially. Ultimately, Risk-Adjusted Return can aid in the development of a balanced portfolio which generates solid returns for an acceptable level of risk.
Examples of Risk Adjusted Return
Stock Market Investments: The most common real world example of risk-adjusted return is investing in the stock market. Let’s say an investor is comparing two stocks: Stock A returned 20% last year while Stock B returned 15%. Without considering risk, one might think Stock A is the better investment. However, on further analysis, if it is found that Stock A is significantly more volatile (or risky) than Stock B, then after adjusting for risk, Stock B may provide a better risk-adjusted return. Tools like the Sharpe ratio can help determine the risk-adjusted return.
Real Estate Investment: Consider an investor who is evaluating two different real estate investments: a Florida beachfront property and a residential property in a stable Midwest city. The potential return for the Florida property is high due to its popular location attracting high-paying renters. However, it also carries high risk (associated with hurricanes and fluctuating tourism). The Midwest property may offer lower potential returns, but also presents less risk (stable residential area, less impact from natural disasters). After adjusting for these risks, the investor may find that the Midwest property offers a better risk-adjusted return.
Mutual Funds and ETFs: Mutual funds or exchange-traded funds (ETFs) that invest in different sectors also have different risk-adjusted returns even if their raw returns are similar. For instance, a technology-specific mutual fund might have higher returns compared to a mutual fund invested in utilities, but it may also be riskier due to the volatility of the technology sector. Using methodologies like the Treynor ratio or the Sortino ratio, investors can compare the performance of different funds on a risk-adjusted basis for investment decisions.
Risk Adjusted Return FAQ
1. What is Risk Adjusted Return?
Risk Adjusted Return is a calculation that takes into consideration the amount of risk involved in producing returns. It provides a more accurate picture of an investment’s profitability by considering the volatility or market risk involved.
2. Why is Risk Adjusted Return Important?
The risk adjusted return is important for determining how much risk is involved in comparison to the potential return on an investment. It allows investors to compare various investments on an equal footing, by taking into account the risk factor.
3. What is the formula for calculating Risk Adjusted Return?
The most common method for calculating risk adjusted return is the Sharpe Ratio. The formula is: (mean portfolio return – risk-free rate) / standard deviation of portfolio return.
4. Is a higher or lower Risk Adjusted Return better?
A higher risk adjusted return is better. It indicates that an investment provides a greater return relative to the amount of risk taken on by the investor.
5. How can one optimize their Risk Adjusted Return?
Investors can optimize their risk adjusted return by diversifying their portfolio, investing in assets with low correlation, taking on more risk for higher return potentials, and carefully evaluating and monitoring the risk levels of their investments.
Related Entrepreneurship Terms
- Sharpe Ratio
- Sortino Ratio
- Alpha (Finance)
- Standard Deviation
- Capital Asset Pricing Model (CAPM)
Sources for More Information
- Investopedia: A comprehensive website dedicated to investing, finance, and market news. For information specifically about Risk Adjusted Return, you can find their dedicated page on this term.
- Morningstar: Offers intensive mutual fund, stock, and ETF research, ratings, and data. They often discuss concepts like Risk Adjusted Return in their reports and articles.
- CFA Institute: A global association of investment professionals that sets the standard for professional excellence and credentials. The organization is a leading voice on global issues related to investment management.
- Yale University: Many academic articles and papers on finance topics like Risk Adjusted Return are published by leading universities like Yale. Their Economics Department or School of Management would be places to look for in-depth, scholarly studies on such topics.
