‘Risk-Adjusted Return’ in a Nutshell

Is the Risk You Are Bearing Giving You Greater Returns?

Risk-adjusted return is a measure of the return on an investment relative to the risk of that investment over a specific period. You can also measure the risk-adjusted return on a fund, a portfolio, or a group of similar investments — similar in terms of risk.

The calculation is not simple. It involves making assumptions about a risk-free rate of return, selecting portfolio and market benchmarks, figuring the standard deviation of return, and/or using ‘beta’ (a separately calculated figure that describes an investment’s tendency to respond to marketplace swings).

Unless you’re a financial analyst, you might think that’s more than you need to know. But for those still curious, I’ll provide a simplified explanation and then give you some resources for studying risk-adjusted return further.

A Simplified Explanation of Risk-Adjusted Return

Let’s say you invest in two different stocks: ‘A’ and ‘B’. You believe that because A is a more prominent, older company with consistent profit growth and returns on equity, and B is much smaller, younger, and more volatile, B is riskier than A. So why did you invest in B if it’s riskier? The reason is that you believe B might grow faster than A in terms of profitability and/or stock price. In other words, as compensation for bearing more risk, you expect a higher return on your investment in B.

Let’s say that after a few years, your portfolio statement shows that the returns on A and B are the same. You might conclude that you would have been wiser to invest all that capital in A because it would have been less risky. A greater return did not reward your willingness to bear greater risk.

As stated, if two investments had the same return over a specific period, the less risky asset would have a better risk-adjusted return.

On the other hand, let’s say that after a few years, B has outperformed A spectacularly. You may conclude that you were very well compensated for your assumed risk.

Let’s look at a more common scenario in which B slightly outperformed A regarding the return on investment. Can you now definitively say that a commensurately better return rewarded the risk you took on your investment in B? Not unless you measure the risk-adjusted returns of A and B.

Diversification Benefit Balances Risk

As I said, that explanation is simplified. It might not be fair to assume that investing in B increased your risk. In fact, investing in both A and B is more diversified than investing solely in A, and diversification helps to minimize risk. Another real-world scenario is that B may have served as a hedge for A, another risk-reducing strategy. Or both are strategically related to other assets in your portfolio.

Modern portfolio theory holds that you must consider an asset’s risk in terms of how its addition to a portfolio affects the risk level of the entire portfolio. That’s known as the asset’s diversification benefit.

Furthermore, calculating risk-adjusted return might be useful as a measure of past performance, but it does not necessarily reliably predict future performance.

3 Methods of Measuring Risk-Adjusted Return

Now, it gets even more complicated. There are a few different ways to measure risk-adjusted return. The best way depends on the characteristics of the assets you’re measuring and the portfolio the assets are in.

Generally, if your portfolio represents your entire investment or contains mostly non-financial assets, the Sharpe ratio is best to measure the risk-adjusted return.

If your portfolio includes many disparate assets and asset classes or if you are measuring only one asset, then Jensen’s alpha or the Treynor ratio may be best, depending on variables such as diversifiable vs. non-diversifiable risk.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Raising Capital: Negotiating with Potential Investors
2. Tricks and Traps in Leveraged Finance
3. Tech Talk: Current Opportunities for Investing

This article was originally published on Feburary 2, 2013 and updated on June 21, 2023. This article was most recently updated by the Financial Poise Editors.] 

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