Risk-Adjusted Return
Risk-adjusted return measures how much profit an investment generates relative to the risk taken to earn it. Rather than looking only at raw returns, these measures compare returns to a benchmark “risk-free” rate (commonly the yield on a 10-year U.S. Treasury) and to various measures of risk, so investors can judge whether higher returns are justified by higher risk.
Why it matters
- Enables apples-to-apples comparisons between investments with different volatility or exposure to market risk.
- Helps assess whether a strategy or fund compensates investors adequately for the risk assumed.
- Useful for portfolio construction and evaluating managers or trading strategies.
Common measures
Sharpe ratio
- Purpose: Measures excess return per unit of total volatility.
- Formula: (Portfolio return − Risk-free rate) / Standard deviation of portfolio returns
- Interpretation: Higher is better. Compares reward relative to total risk (both systematic and idiosyncratic).
- Example: If Fund A returns 12%, Fund B 10%, risk-free rate 3%, and SDs are 10% and 7% respectively:
- Fund A Sharpe = (12% − 3%) / 10% = 0.9
- Fund B Sharpe = (10% − 3%) / 7% ≈ 1.0
- Fund B has the better risk-adjusted return by this measure.
Treynor ratio
- Purpose: Measures excess return per unit of systematic (market) risk.
- Formula: (Portfolio return − Risk-free rate) / Beta
- Interpretation: Higher is better. Uses beta to focus on market-related risk; best for well-diversified portfolios where idiosyncratic risk is minimal.
- Example (beta = 0.75 for both funds):
- Fund A Treynor = (12% − 3%) / 0.75 = 12%
- Fund B Treynor = (10% − 3%) / 0.75 ≈ 9.3%
- Fund A delivers more return per unit of systematic risk.
Other useful metrics
- Alpha: Absolute return above (or below) a chosen benchmark after adjusting for risk — a measure of manager skill or added value.
- Beta: Sensitivity to market movements. Market beta = 1; >1 = more volatile than market; <1 = less volatile.
- Standard deviation: Volatility of returns; higher values indicate wider swings.
- R-squared: Proportion of an investment’s returns explained by an index (useful to evaluate how closely a fund tracks a benchmark).
How to use risk-adjusted measures
- Always compare investments using the same risk metric (e.g., compare Sharpe-to-Sharpe or Treynor-to-Treynor).
- Match the measure to the context: use Treynor for diversified portfolios (focus on systematic risk), Sharpe when total volatility matters.
- Choose an appropriate time horizon; short periods can produce misleading ratios due to transient volatility or outliers.
Important considerations and limitations
- Higher risk can produce higher returns over full market cycles—but also larger losses in downturns.
- Risk-averse choices aren’t inherently better; a lower-risk fund may underperform in bull markets.
- Ratios depend on inputs (return period, chosen risk-free rate, estimation of volatility/beta). Different choices yield different results.
- These metrics are tools, not definitive answers. Use them alongside qualitative analysis and other financial measures.
Practical examples beyond equities
- Real estate and alternative assets can be evaluated with the same methods if you have return and volatility data. For example, compute a property’s historical mean return and standard deviation, subtract a risk-free rate, and apply the Sharpe formula.
Bottom line
Risk-adjusted return metrics—such as the Sharpe and Treynor ratios, alpha, beta, and standard deviation—help determine whether returns justify the risks taken. Use the same risk measure when comparing investments, align the metric with your portfolio context, and be mindful of input choices and time horizons when interpreting results.