The Concept of Risk-Adjusted Returns and Why You Must Understand It

Let’s start with a simple example. Imagine you invest in a stock at $5, and after a year, its value rises to $10. Your profit is $5. This is your return, at least, in simple terms, it is.

However, this calculation does not provide the complete picture. When evaluating your returns, it is important to consider additional factors, one of the most important being risk. In technical terms, this is known as risk-adjusted returns.

Risk-adjusted returns help you understand how much return you are earning relative to the risk you are taking. For example, if you invest $5 in a very risky stock, the profit of $5 is different from earning the same profit on a relatively stable stock.

To better understand this concept, you may consider speaking to a financial advisor. Once you know how a risk-adjusted return on investments works, you may be able to avoid unnecessary risks and invest more mindfully. This article can get you up to speed. 

What is risk-adjusted return?

Imagine you invest in a stock that promises a 15% return. That sounds great, right? Anyone would be excited about earning a high return. But what if that investment also comes with a lot of risk? Would your decision change if there were a chance you could lose a large portion, if not all, of your money? 

Is that 15% return really worth the risk you are taking?

To answer this question, you need to understand risk-adjusted returns on investments. 

Risk-adjusted return allows you to calculate the return you can make from an investment compared to the risk involved. It does not just look at how much money you can possibly pocket as a profit. It also looks at how uncertain this investment can be if the market does not work as you want it to.

There are different types of returns that you can earn from an investment. For instance, there is an absolute return, which is the overall growth of your investment. So, if you invested money and it increased by 15%, that is your absolute return. 

But risk-adjusted return can be slightly different. And the reason you need to know about it is that investments that give the same absolute return can involve very different levels of risk.

For example:

• One investment gives you a steady 15% return with no fluctuations.
• The second investment also gives you 15%, but there may be significant fluctuations down the road.

Even though the returns look the same on paper, the second investment is much riskier. This is because the risk-adjusted returns for both investments differ. 

Risk-adjusted returns factor in volatility. They help you see clearly that focusing solely on high returns can be misleading. An investment that seems like the right option because of high returns may actually carry significant hidden risk. And if you do not have a high-risk appetite or long investment horizon, you could end up facing losses or unnecessary stress.

How to calculate risk-adjusted return?

Now there are multiple ways to calculate risk-adjusted return. Let’s take a look at them:

1. Risk-adjusted Return on Capital (RAROC)

The RAROC helps you understand how your capital is being used after accounting for risk. It accounts for revenue, expected losses, and capital, and helps you understand how much return you are really making. It is a straightforward calculation and helps you understand your return from an investment by factoring in the risks and costs involved.

Here is the formula: 

RAROC = (r − e − el + ifc) / c

Where:

• r = Revenue
• e = Expenses
• el = Expected loss
• ifc = Income from capital. It is calculated as capital charges × risk-free rate
• c = Capital

2. Sharpe ratio

The Sharpe ratio is a commonly used measure of risk-adjusted returns. It is quite easy, too. Here is the formula:

Sharpe ratio = Return − Risk-free rate/ Standard deviation

Let’s break this down:

• Return = The return you earn from your investment.
• Risk-free rate = The return you could earn from a safe investment.
• Standard deviation = This is a measure of how much the investment’s returns fluctuate. It helps you understand the level of volatility associated with an investment.

What this formula does is calculate how much extra return you are earning compared to a risk-free investment, and then adjusts it based on how volatile the investment is. 

Here is how to interpret it:

• A Sharpe ratio above 1.0 is considered good
• Above 2.0 is very good
• Above 3.0 is excellent

The higher the ratio, the better your return is relative to the risk you are taking.

3. Sortino ratio

The Sortino ratio is similar to the Sharpe ratio, but with one key difference – it considers only downside risk. In simple terms, it ignores volatility when the market rises and focuses only on risk when returns fall below a certain level. This makes it especially useful if you are more concerned about losses than fluctuations in general.

Here is the formula:

Sortino ratio = Return − Risk-free rate/ Downside deviation

The Sortino ratio tells you how much extra return you are earning for the downside risk you are taking. If you want to avoid losses more than anything else, this ratio can give you a clearer picture.

4. Treynor ratio

The Treynor ratio is another method for calculating risk-adjusted returns. It takes a different approach, though. Instead of looking at total volatility, it focuses only on market-related risk, also known as systematic risk. This type of risk is tied to overall market movements.

Here is the formula:

Treynor ratio = Return − Risk-Free Rate/ Beta, also written as β

Here, 

• Beta (β) measures how sensitive an investment is to market movements.

The Treynor ratio helps you understand how well an investment performs relative to the level of market risk it is exposed to. 

Why do you need to understand risk-adjusted investment returns?

Here are some reasons why understanding and evaluating risk-adjusted investment returns can be important for investors:

1. It helps you see the full picture

Risk-adjusted returns bring balance to your decision-making. They force you to look at both sides of the equation:

• The reward
• The risk

All investments are impacted by these two factors. Hence, it is important for you to understand how they are correlated. Two investments might deliver the same return, but if one has a lower or higher risk profile, its suitability for your portfolio changes. Without considering risk, it is easy to make decisions solely based on what looks good on paper. But you may end up completely ignoring the fact that the investment may not align with your comfort level or financial goals.

2. It shifts your mindset

Understanding risk-adjusted investment returns changes the way you think about investing. You are more likely to make informed, intentional decisions. Instead of just focusing on how much you can earn, you also consider and reflect on whether the return is worth the level of risk involved. 

3. It helps you make decisions depending on your situation

Your personal and financial situation plays a huge role in how much risk you should take.

For example, if you are approaching retirement and have a lower risk appetite, risky investments may not be the right option for you. The downside risk may just be too much, considering the fact that you could end up losing a good portion of your savings at a time when you should be preserving your wealth. Losses at this time can have serious and lasting consequences.

On the other hand, if you are in your 30s or 40s and in the prime of your career with years left until retirement, you may be able to ignore risk and invest in high-reward options, simply because you would have time to recover from market fluctuations.

4. It prevents overreacting

It is important to remember that the purpose of understanding risk-adjusted investment returns is not to avoid risk completely. Being overly cautious about taking on risk at the wrong time can actually hurt you in the long run. High-risk investments carry a higher risk of larger losses during volatile periods, but they may outperform more conservative options and provide long-term growth, too.

Understanding risk-adjusted return on investment gives you the information you need not to overreact to short-term performance or let your emotions get in the way. Risk-adjusted returns help you invest with perspective. When you factor in both risk and reward, you can:

• Stay focused on your long-term financial goals
• Choose investments that match your risk tolerance
• Avoid being misled by the potential of high returns

How can you evaluate risk-adjusted returns?

Here’s how:

Step 1: Start with your goals

Before looking at any investment, take a step back and ask yourself what you are investing for – are your goals short-term? Or are they long-term?

Your timeline plays a big role in how much risk you can afford to take. Generally, you may be able to take on more risk for long-term goals. On the other hand, if you are preparing for short-term goals, you may want to limit risk and protect your capital. 

Step 2: Understand your risk appetite

Think about how you would react if your investment suffered losses to understand your capacity for taking on risk. Your risk appetite would also depend on other factors, such as your age, income, goals, and more. 

Step 3: Use risk-adjusted metrics or get help from a financial advisor

Once you have aligned your goals and situation, you can look at risk-adjusted return metrics such as:

• RAROC
• Sharpe ratio
• Sortino ratio
• Treynor ratio

These tools help you compare how much return an investment generates relative to the level of risk it entails. You can also consult a financial advisor who can break down these metrics.

Step 4: Make a decision

Finally, bring everything together, including your goals, risk tolerance, financial situation, and the investment’s risk-adjusted performance. Then ask yourself if you would still want to invest. 

Risk-adjusted return on investment – A powerful tool for every investor

Understanding risk-adjusted returns gives you a more complete view of an investment. This naturally leads to better-informed decision-making. It also helps you align your investments with your goals. Another advantage is that this approach works for everyone. So, whether you are new to investing or more experienced, you can use it to your advantage.

If you are unsure how to evaluate this for your own portfolio, it can be helpful to speak with a financial advisor. Our financial advisor directory can help you hire an advisor near you who can simplify the concept of risk-adjusted returns.  

Frequently Asked Questions (FAQs) about risk-adjusted return on investment

1. What is risk-adjusted return?

Risk-adjusted return allows you to calculate investment returns after factoring in risk. It helps you understand the volatility associated with investing in a particular asset, so you can make informed decisions. 

2. How can I calculate risk-adjusted returns on an investment?

There are several ways to calculate risk-adjusted returns on an investment. Here are some metrics that can help:

• RAROC
• Sharpe ratio
• Sortino ratio
• Treynor ratio

While calculating these on your own can be a bit tricky, bringing a financial advisor on board can help. Advisors can simplify these calculations and help you figure out how these metrics affect your investments.

3. Should you only look at the risk-adjusted returns on an investment when making decisions?

No, you need to look further. While risk-adjusted returns can be a helpful metric, you must also consider other factors. Risk-adjusted returns may overlook factors such as historical data, personal financial goals, macroeconomic conditions, and more. So, it is important to evaluate your financial goals, time horizon, market conditions, personal preferences, taxes, costs, and fees when arriving at a decision.