Risk Adjusted Returns
Understanding Risk Adjusted Returns
To invest wisely, it’s crucial to understand not just the returns but the risks taken to achieve those returns. Risk adjusted returns provide this deeper insight, allowing us to make more informed comparisons between investments.
Key Concepts in Risk Adjusted Returns
Risk adjusted returns are investment returns that have been modified to account for the risk involved in producing those returns.
It’s a tool we use to compare the performance of investment portfolios with differing risk profiles.
Essentially, these returns allow us to determine how much risk was taken to achieve a level of performance and whether the investment was worth the risk when compared to a risk-free investment.
Calculating Risk Adjusted Returns
We calculate risk adjusted returns by comparing the returns of an investment to the risk-free rate of return—typically the return on government bonds.
To illustrate, if an investment portfolio provides a 10% return and the risk-free rate is 3%, the excess return is 7%. This excess return is then divided by the investment’s standard deviation—a measure of risk—to yield the risk adjusted return.
Applications in Portfolio Management
Understanding risk adjusted returns is especially valuable in the context of portfolio management. It aids us in evaluating the performance of portfolio managers and in making asset allocation decisions.
A portfolio manager’s ability to generate superior risk adjusted returns is a testament to their skill in choosing investments and managing risk, compared to a benchmark index or their peers.
Tools and Ratios
Several tools and ratios are at our disposal to evaluate risk adjusted returns. The Sharpe Ratio, for instance, is a commonly used metric that divides the excess return over the risk-free rate by the standard deviation of return.
Similarly, the Information Ratio is another valuable tool that measures a portfolio’s return relative to the return of a benchmark index, adjusted for the volatility of those returns.
Comparing Investment Opportunities
When it comes to comparing investment opportunities, it’s not sufficient to only look at absolute returns. We must factor in risk.
An investment with lower absolute returns but also lower risk might be more attractive than one with higher returns and a significantly higher risk.
This is where the tools and ratios mentioned above provide us great service, allowing us to make apples-to-apples comparisons across diverse investment scenarios.