Risk-adjusted return refines an investment's return by measuring how much risk is involved in producing that return, which is generally expressed as a number or rating. Risk-adjusted returns are applied to individual securities, investment funds and portfolios.

Some common risk measures include alpha, beta, R-squared, standard deviation and the Sharpe ratio. When comparing two or more potential investments, an investor should always compare the same risk measures to each different investment to get a relative performance perspective.

Next Up

In its simplest definition, risk-adjusted return is of how much return your investment has made relative to the amount of risk the investment has taken over a given period of time. If two or more investments have the same return over a given time period, the one that has the lowest risk will have the better risk-adjusted return. However, considering that different risk measurements give investors very different analytical results, it is important to be clear on what type of risk-adjusted return is being considered. Below are examples of conflicting risk-adjusted return calculations and their implications.

Sharpe Ratio Example

The Sharpe ratio is a measure of an investment's excess return, above the risk-free rate, per unit of standard deviation. It is calculated by taking the return of the investment, subtracting the risk-free rate, and dividing this result by the investment's standard deviation. All else equal, a higher Sharpe ratio is better. The standard deviation shows the volatility of an investment's returns relative to its average return. Greater standard deviations reflects wider returns, and narrower standard deviations imply more concentrated returns. The risk-free rate is the yield on a no-risk investment, such as a Treasury bond.

Mutual Fund A returns 12% over the past year and had a standard deviation of 10%. Mutual Fund B returns 10% and had a standard deviation of 7%. The risk-free rate over the time period was 3%. The Sharpe ratios would be calculated as follows:

Mutual Fund A: (12% - 3%) / 10% = 0.9

Mutual Fund B: (10% - 3%) / 7% = 1

Even though Mutual Fund A had a higher return, Mutual Fund B had a higher risk-adjusted return, meaning that it gained more per unit of total risk than Mutual Fund A.

Treynor Ratio Example

The Treynor ratio is calculated the same way as the Sharpe ratio, but it uses the investment's beta in the denominator. A higher Treynor ratio is better. Using the previous fund example, and assuming that each of the funds has a beta of 0.75, the calculations are as follows:

Mutual Fund A: (12% - 3%) / 0.75 = 0.12

Mutual Fund B: (10% - 3%) / 0.75 = 0.09

Here, Mutual Fund A has a higher Treynor ratio, meaning that the fund is earning more return per unit of systematic risk than Fund B. Given this result and the result of the Sharpe ratio calculation, it can be concluded that Fund B is more efficiently earning returns per unit of unsystematic risk.

Risk-adjusted returns can have a severe impact on portfolios. In strong markets, a fund with lower risk than the benchmark can limit returns, and a fund that entertains more risk than the benchmark may experience more sizable returns. It has been shown that, while losses may accrue in higher-risk funds during volatile periods, funds with a greater appetite for risk are more likely to outperform their benchmarks over full market cycles.

RELATED TERMS
1. Sharpe Ratio

The Sharpe ratio is the average return earned in excess of the ...
2. Information Ratio (IR)

The information ratio is a ratio of portfolio returns beyond ...
3. Risk Measures

Risk measures give investors an idea of the volatility of a fund ...
4. Relative Return

Relative return is the return an asset achieves over a period ...
5. Appraisal Ratio

The appraisal ratio is a ratio used to measure the quality of ...
6. Risk Management

Risk management occurs anytime an investor or fund manager analyzes ...
Related Articles
1. Investing

Understanding The Sharpe Ratio

The Sharpe ratio describes how much excess return you are receiving for the extra volatility that you endure for holding a riskier asset.

Measuring the success of your investment solely on the portfolio return may leave you blindsided to risk. Learn how to evaluate your investment return.
3. Investing

4. Investing

PRHSX: Risk Statistics of Health Sciences Mutual Fund

Examine the risk metric of the T. Rowe Price Health Sciences Fund. Analyze beta, capture ratios and standard deviation to assess volatility and systematic risk.
5. Investing

Understanding Volatility Measurements

How do you choose a fund with an optimal risk-reward combination? Here we teach you about standard deviation, beta and more.
6. Investing

How to Use a Benchmark to Evaluate a Portfolio

What is an investment benchmark and how is it used to evaluate the risk and return in a portfolio.
7. Investing

3 Ways To Evaluate the Performance of Alternatives

Learn about three ways to measure the performance of alternative investments. See how the commonly used Sharpe ratio has drawbacks in measuring volatility.
8. Investing

Find Out All About Vanguard 500 Index Fund!

Discover a risk statistics case study of the Vanguard 500 Index Fund, and learn about its historical beta, alpha, Treynor ratio and volatility.
9. Investing

FSPHX: Fidelity’s Mutual Fund for Health Care or Medicine

Analyze the risk metrics of FSPHX. Find out what beta, standard deviation and R-squared imply about volatility and market correlation.
10. Investing

T Rowe Price Capital Appreciation Fund Risk Statistics Case Study (PRWCX)

Analyze PRWCX using popular risk metrics that are part of modern portfolio theory (MPT). Explore PRWCX's volatility, correlation and return statistics.
RELATED FAQS
1. What is the difference between a Sharpe ratio and a Traynor ratio?

Understand the difference between two methods of evaluating portfolio returns on investment, the Sharpe ratio and the Treynor ... Read Answer >>
2. How do you the calculate Sharpe ratio in Excel?

Learn how to use Microsoft Excel to calculate the Sharpe ratio, an investing tool used to assess the relationship between ... Read Answer >>
3. How is standard deviation used to determine risk?

Understand the basics of calculation and interpretation of standard deviation, and how it is used to measure and determine ... Read Answer >>
4. What is a good annual return for a mutual fund?

Before investing in mutual funds, it's important to understand individual goals for the investment over a specified time ... Read Answer >>
Hot Definitions
1. Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
2. Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
3. Financial Risk

Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
4. Enterprise Value (EV)

Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
5. Relative Strength Index - RSI

Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
6. Dividend

A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.