The Concept of Risk-Adjusted Returns and Why You Must Understand It
Market uncertainties have had a major influence on recent economic times. Investors who used forecasts and technical projections to safeguard their future now refrain from making undeviating judgments. Instead, they now rely more on strategies to encumber risks from their plans. It would be fitting to deduce that management and allocation of risk has now become a matter of the moment.
Investment plans and retirement strategies these days focus on innovative customs to manage and attribute risk, thereby reinforcing good returns. Risk-adjusted returns is one such concept that has the potential to help individuals make more tactical decisions.
Gaining knowledge about returns attuned to risk can provide various options to deal with potential market fluctuations, but one has to dwell deeper into insights to know this methodology in detail. Here’s what you must know.
Understanding Risk-Adjusted Returns
Risk-adjusted return is a process of analyzing risks associated with an investment asset. It is used to devise out a plan containing comparatively low risk. If an instrument has risk levels that are lower than the market, the return will usually be on the higher side. Conversely, if the risk levels are higher than the market value, the chances of risk-free returns can decline.
An assuring security asset might be perceived differently, if we consider the risk involved with it. In a way, the amount of assumed risk is more important than your gross income return.
The process of risk-adjusted returns is utilized to get a clearer picture of the return by showing the standard deviation from its expected value. It also helps provide an estimate for the total portfolio risk of a risk-free environment. Let’s assume that an asset A has performed better than asset B over a time period of one year. It goes without saying that asset A is better. But this may not be the case if you account the risk associated with asset A, which might be bigger than B.
Risk adjusted returns can have many benefits, such as:
Evaluation of Investments
Risk-adjusted returns help us evaluate financial, operational, market and credit risks. By obtaining a clear picture of the financial hazards involved in each investment, we can improvise our decision making and create a portfolio accordingly. The process helps us understand whether the investment is worth our capital or not, given the amount of risk it poses. The approach also provides a fish-eye view of short and long term volatility. By adjusting returns on the basis of risk, you eliminate the uncertainty of losses in critical economic situations and market fluctuations. This also contributes to more psychological stability and peace of mind.
Quality Assurance of Assets
Risk-adjusted returns are an assuring way to measure the quality of your asset. It defines shortcomings, upside return, and the profit probability of an asset. Instead of showing only the key benefits, it takes into account a full breadth of descriptive analysis of an instrument. It shows minor and major changes in positions each day and removes the chances of farcical overseeing and visualization. Likewise, utilizing the process is also fairly simple. You need to define loss, risk, and the probability, and then compare it with the current market price.
Improvement of Plan
A major advantage of risk-adjusted returns is that it helps fine-tune your plan with regular updates and prolific alterations. When you have an estimate of both returns and risk, you can easily plan ahead. This makes the road to future speculation a lot simpler. The concept also enables us to compare the returns of various assets and their portfolios. You can easily equate the risk levels of bonds, stocks, mutual funds, etc. with a standard profile of reference.
Increase in Profit
As you progress ahead by adjusting risk towards every investment, there may come a time when you may realize that your goals just do not match the market standards. Anchoring your decisions, risk-adjusted returns can help you to update, modify, and improve your portfolio. It helps you eliminate frail strategies while welcoming better ones. This can result in a smart plan that yields higher returns. Also, when the risk is distributed, every decision you take thereon will result in an increase in the profit value of the instruments.
Calculating Risk-Adjusted Returns
There are several methods to calculate risk-adjusted returns. For example:
Sharp Ratio describes the strength of the return to compensate for the amount of risk taken. The formula operates by placing two assets in comparison to a standard benchmark and then calculating the Sharp Ratio of both. An asset with a higher number usually indicates better returns for the same amount of risk. Sharp Ratio can be calculated by subtracting the Expected Return of a portfolio by the Risk-Free rate and then dividing the answer by the Standard Portfolio Deviation. The data is normally distributed which usually results in more accurate results.
In this method, market index is used as a standard output to conclude the strength of an investment. The excess returns in comparison to the market standard are considered as the Jensen Alpha. The alpha shows how an investment is performing after bearing the risk of the market. The metrics involved here are Expected Portfolio Return, Market Return, Risk-Free Rate, and Standard portfolio Beta. Here’s the formula:
Jensen Alpha = Expected Portfolio Return – Risk-free return – Portfolio Beta (Market Return – Risk-Free Rate)
This is somewhat similar to Sharp Ratio; the only difference lies in the use of Portfolio Beta instead of Standard Deviation in the formula. Treynor Ratio describes the number of extra returns earned in an asset. The formula is calculated by subtracting Expected Portfolio Return from Risk-Free Rate and then dividing the answer by the Beta Coefficient. Some other methods used to calculate risk-adjusted returns are:
- Modigliani performance method
- R-squared method
- Sortino ratio
No matter which method you intend to choose, the final answer can vary from person to person depending on factors such as fund availability, ability to hold a position in the market, trust in asset behavior, and risk tolerance. If an individual commits a calculative mistake, the tax condition along with the price of the lost opportunity can also affect the result in all of the above-mentioned formulas.
To Sum it Up
Risk-adjusted returns have the potential to impart a deep influence on your portfolio. The approach takes into account sound methodology and common wisdom which are the building blocks of risk-elimination in the future. The discipline can be utilized to define fundamental return-elevating means in differing market conditions and make better decisions.
Do you wish to increase your risk-adjusted returns? Contact financial advisors for help on how to adopt the strategy in your investment plans.