Risk-adjusted return

Definition

Risk-adjusted return is a measure of the return on an investment that takes into account the risk associated with it. This concept allows investors to evaluate the performance of an investment relative to the amount of risk taken, enabling them to compare different investment opportunities more effectively. By factoring in risk, investors can make more informed decisions and identify investments that provide the best potential returns for the level of risk they are willing to accept.

5 Must Know Facts For Your Next Test

1. Risk-adjusted return is calculated using various metrics, including the Sharpe ratio and Sortino ratio, which help to standardize returns based on risk levels.
2. This measure helps investors understand whether they are being adequately compensated for taking on additional risk by comparing the expected returns against the risk profile.
3. Investors often use risk-adjusted returns to assess and compare the performance of mutual funds, ETFs, and individual stocks in order to make better allocation decisions.
4. Risk-adjusted return is particularly useful in portfolio management, as it aids in balancing the mix of high-risk and low-risk investments based on overall investment goals.
5. Higher risk does not always equate to higher returns; understanding risk-adjusted return helps investors avoid potentially poor investments that do not provide sufficient reward for their risk exposure.

Review Questions

• How does incorporating risk-adjusted return into investment evaluation improve decision-making for investors?
  • Incorporating risk-adjusted return into investment evaluation allows investors to assess their potential returns relative to the risks they are willing to take. This approach helps in identifying investments that offer higher expected returns for a given level of risk. By focusing on risk-adjusted metrics like the Sharpe ratio, investors can make more informed choices and optimize their portfolios by balancing risky assets with safer alternatives.
• Discuss how different metrics like Sharpe ratio and Sortino ratio contribute to understanding risk-adjusted return.
  • The Sharpe ratio and Sortino ratio are critical tools for measuring risk-adjusted return. The Sharpe ratio evaluates how much excess return an investment provides per unit of total risk, while the Sortino ratio specifically measures excess return per unit of downside risk. Both ratios help investors determine whether a particular investment is worth its associated risks, enabling better comparisons between different investment options based on their respective performances relative to their risks.
• Evaluate the impact of ignoring risk when assessing investment returns and how this relates to achieving long-term financial goals.
  • Ignoring risk when assessing investment returns can lead to significant misjudgments, potentially resulting in poor investment choices that may jeopardize long-term financial goals. Without considering how much risk is taken for the returns expected, investors might pursue high-return investments that carry excessive volatility or downside potential. This oversight can result in severe losses during market downturns, undermining overall portfolio performance and hindering progress toward financial objectives.

Related terms

Volatility: A statistical measure of the dispersion of returns for a given security or market index, indicating how much the price of an asset varies over time.

Sharpe Ratio: A ratio that measures the performance of an investment compared to a risk-free asset, accounting for its risk, used to understand how much excess return is received for the extra volatility endured.

Alpha: A measure of an investment's performance on a risk-adjusted basis, representing the value that a portfolio manager adds or subtracts from a fund's return.