What Is Risk Adjusted Return?
Risk adjusted return is a crucial metric within portfolio management and a core concept in financial metrics that evaluates an investment's return relative to the amount of risk taken to achieve that return. Unlike simple return, which only considers the gain or loss on an investment, risk adjusted return provides a more holistic view by incorporating the inherent volatility or uncertainty of the investment. It helps investors and analysts compare different investment opportunities on a level playing field, even if they have vastly different risk profiles. This concept is fundamental to understanding whether a higher return was merely a result of taking on excessive risk or if it truly reflects superior investment strategy or skill.
History and Origin
The concept of evaluating returns in the context of risk gained significant traction with the advent of Modern Portfolio Theory (MPT) in the 1950s, pioneered by Harry Markowitz. MPT provided a framework for optimizing portfolios based on the trade-off between risk and expected return. Building on Markowitz's work, William F. Sharpe introduced the Capital Asset Pricing Model (CAPM) in the 1960s, which provided a way to calculate the expected return of an asset given its systematic risk. Markowitz and Sharpe, along with Merton Miller, were awarded the Nobel Prize in Economic Sciences in 1990 for their foundational contributions to financial economics, which underpin the modern understanding and calculation of risk-adjusted returns.8
Key Takeaways
- Risk adjusted return quantifies the return earned for each unit of risk assumed by an investment.
- It allows for a more meaningful comparison of investment performance across assets with varying levels of risk.
- Common measures include the Sharpe ratio, Treynor ratio, and Jensen's Alpha.
- A higher risk adjusted return generally indicates a more efficient and desirable investment, as it suggests better compensation for the risk undertaken.
- Understanding risk adjusted return is vital for effective diversification and asset allocation.
Formula and Calculation
Several formulas exist to calculate risk adjusted return, each emphasizing different aspects of risk. The Sharpe ratio is one of the most widely used and measures the excess return per unit of total risk (as measured by standard deviation).
Sharpe Ratio Formula:
Where:
- ( S_p ) = Sharpe ratio of the portfolio
- ( R_p ) = Return of the portfolio
- ( R_f ) = Risk-free rate of return (e.g., return on a U.S. Treasury bill)
- ( \sigma_p ) = Standard deviation of the portfolio's excess return (a measure of its volatility or total risk)
Other key risk adjusted return metrics include:
- Treynor Ratio: Similar to the Sharpe ratio, but it uses Beta (a measure of systematic risk) in the denominator instead of standard deviation.
- Jensen's Alpha: Measures the excess return of a portfolio relative to the return predicted by the Capital Asset Pricing Model (CAPM), given the portfolio's Beta.
Interpreting the Risk Adjusted Return
Interpreting risk adjusted return involves comparing the calculated metric to those of benchmarks, peers, or other investment opportunities. A higher Sharpe ratio, for instance, implies that an investment is generating more return for each unit of risk, making it more attractive from a total risk perspective. When comparing two investments with similar simple returns, the one with a higher risk adjusted return is generally preferred because it achieved that return with less volatility. This evaluation helps investors make informed decisions that align with their risk tolerance and financial objectives.
Hypothetical Example
Consider two hypothetical portfolios, Portfolio A and Portfolio B, over a five-year period. The risk-free rate is 2%.
- Portfolio A:
- Average Annual Return ((R_p)): 10%
- Standard Deviation ((\sigma_p)): 8%
- Portfolio B:
- Average Annual Return ((R_p)): 12%
- Standard Deviation ((\sigma_p)): 15%
Let's calculate the Sharpe Ratio for each:
Portfolio A Sharpe Ratio:
Portfolio B Sharpe Ratio:
Even though Portfolio B had a higher average return (12% vs. 10%), Portfolio A has a higher Sharpe Ratio (1.00 vs. 0.67). This indicates that Portfolio A delivered superior risk adjusted return, meaning it generated more return for each unit of risk taken compared to Portfolio B. An investor focused on optimizing the balance between risk and return would likely prefer Portfolio A, demonstrating the value of this metric in investment decision making.
Practical Applications
Risk adjusted return metrics are widely used across the financial industry to assess and compare investment performance. Fund managers employ them to demonstrate their skill in generating returns efficiently, while institutional investors and financial advisors use them to select and monitor investment vehicles. These metrics are crucial in areas such as:
- Fund Selection: Comparing mutual funds, hedge funds, and other pooled investment vehicles.
- Performance Attribution: Understanding whether returns are due to market exposure, manager skill, or excessive risk-taking.
- Regulatory Compliance: Some regulatory frameworks consider risk in performance reporting. The International Monetary Fund (IMF) and other global bodies often analyze risk-adjusted performance in broader financial stability assessments.7
They provide a standardized way to evaluate how well an asset or portfolio compensates investors for the risks they undertake, beyond just simple nominal returns.
Limitations and Criticisms
While invaluable, risk adjusted return metrics have limitations. The most common criticism revolves around their reliance on historical data, which may not be indicative of future performance. For instance, the standard deviation assumes returns are normally distributed, which is often not the case for financial assets, especially during periods of extreme market events. The choice of the risk-free rate can also significantly impact the result. Furthermore, some metrics, like the Sharpe Ratio, penalize both upside and downside volatility equally, which may not align with an investor's true perception of risk.
Financial researchers and practitioners have highlighted these challenges. For example, Research Affiliates has published work cautioning against "chasing" risk-adjusted returns without fully understanding the underlying assumptions and potential pitfalls. These metrics also often struggle to fully capture all types of risk, such as liquidity risk or tail risk, leading to a potentially incomplete picture of an investment's true risk profile. Investors must use these metrics as part of a broader analysis, considering qualitative factors and their own investment objectives and risk tolerance.
Risk Adjusted Return vs. Absolute Return
Absolute return refers to the simple percentage gain or loss that an investment achieves over a specific period, without reference to any benchmark or risk taken. For example, if an investment starts at $100 and ends at $110, its absolute return is 10%. This metric is straightforward and easy to understand, but it provides no context about the risk involved in achieving that return.
In contrast, risk adjusted return explicitly incorporates the level of risk assumed. It seeks to answer whether the absolute return was "worth" the risk, or if the return could have been achieved with less risk, or if a higher return should have been expected given the risk. An investment with a high absolute return might be less desirable than one with a lower absolute return if the former involved disproportionately higher risk, as discussed by institutions like the St. Louis Fed when examining the fundamental relationship between risk and return.6 The key difference lies in the qualitative insight: absolute return tells you "how much," while risk adjusted return tells you "how well" that amount was achieved relative to the exposure to risk.
FAQs
What does a good risk adjusted return look like?
A "good" risk adjusted return is generally indicated by a higher numerical value for metrics like the Sharpe or Treynor ratios. For example, a Sharpe ratio above 1.0 is often considered good, meaning the investment returned more than its risk-free rate for each unit of total risk taken. However, what constitutes "good" can vary depending on the asset class, market conditions, and the specific benchmark being used for comparison.
Why is risk adjusted return important for investors?
It is crucial for investors because it helps them make more informed decisions by providing a clearer picture of an investment's true performance. Focusing solely on nominal returns can be misleading, as higher returns often come with higher risk. By considering risk, investors can choose assets that align with their risk tolerance and contribute efficiently to their overall portfolio objectives.
Can risk adjusted return predict future performance?
No, risk adjusted return, like all performance metrics based on historical data, does not guarantee or predict future performance. It is a backward-looking measure. While it helps in evaluating past efficiency, future market conditions, economic shifts, and unforeseen events can significantly impact an investment's actual returns and volatility. Investors should use it as part of a comprehensive analysis, not as a standalone predictive tool.
What are common ways to improve risk adjusted return?
Improving risk adjusted return typically involves strategies that either enhance returns without proportionally increasing risk, or reduce risk without severely sacrificing returns. This can be achieved through effective diversification across various asset classes and geographies, careful security selection, strategic asset allocation, and managing overall portfolio volatility. Reducing unnecessary costs and fees can also indirectly improve risk-adjusted outcomes by boosting net returns.
Is a higher risk adjusted return always better?
Generally, a higher risk adjusted return is preferred, as it signifies greater efficiency in generating returns relative to the risk undertaken. However, context is key. Extremely high ratios could sometimes signal unusual, short-term anomalies or data biases. It's important to analyze the components (return, risk, and risk-free rate) and compare them within the appropriate asset class and market environment to ensure the metric accurately reflects the investment's quality and is not simply an outlier.123, 4, 5