Risk-Adjusted Return
What Is Risk-Adjusted Return?
Risk-adjusted return measures how much return an investment generates relative to the level of risk taken. It evaluates whether higher returns are the result of effective investing or simply higher risk exposure.
This concept is commonly used to compare investment performance across different strategies.
Why It Matters
Two investments may generate similar returns, but the one with lower risk may be considered the better investment.
Risk-adjusted return helps investors determine whether an investment’s performance justifies the risk involved.
Professional investors and portfolio managers frequently use risk-adjusted metrics to evaluate strategies.
How Risk-Adjusted Return Works
Risk-adjusted return considers both:
- total investment return
the volatility or risk associated with that return
Common measures of risk-adjusted return include:
- Sharpe ratio
- Sortino ratio
- information ratio
These metrics help investors compare investments on a more meaningful basis.
Example
If two funds both produce a 10% annual return but one experiences significantly larger price swings, the less volatile fund may have a better risk-adjusted return.
Risk-Adjusted Return vs Total Return
- Risk-adjusted return considers both return and risk.
- Total return measures investment gains without accounting for risk.
FAQs About Risk-Adjusted Return
Why do investors focus on risk-adjusted returns?
Because strong returns achieved with excessive risk may not be sustainable.
Which metric measures risk-adjusted return?
Common metrics include the Sharpe ratio and Sortino ratio.
Do professional investors use risk-adjusted analysis?
Yes. It is widely used in portfolio management.
Related Terms
