Understanding Risk-Adjusted Return and Measurement Methods

What Is a Risk-Adjusted Return?

A risk-adjusted return is a calculation of the profit or potential profit from an investment that considers the degree of risk that must be accepted to achieve it. The risk is measured in comparison to that of a virtually risk-free investment—usually U.S. Treasuries.

Depending on the method used, the risk calculation is expressed as a number or a rating. Risk-adjusted returns are applied to individual stocks, investment funds, and entire portfolios.

Understanding Risk-Adjusted Return

The risk-adjusted return measures the profit your investment has made relative to the amount of risk the investment has represented throughout a period. If two or more investments delivered the same return over a given time, the one with the lowest risk will have a better risk-adjusted return. Analysts can use a MAR ratio to compare the performance of trading strategies, hedge funds, and even trading advisors.

Some common risk measures used in investing include alpha, beta, R-squared, standard deviation, and the Sharpe ratio. When comparing two or more potential investments, you should apply the same risk measure to each investment under consideration to get a relative performance perspective.

Examples of Risk-Adjusted Return Methods

Here is a breakdown of the most commonly used measurements.

Sharpe Ratio

The Sharpe ratio measures the profit of an investment that exceeds 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 risk-free rate used is the yield on very low-risk investment, usually the 10-year Treasury bond (T-bond), for the relevant period.

For example, say Mutual Fund A returned 12% over the past year and had a standard deviation of 10%. Mutual Fund B returned 10% with a standard deviation of 7%, and the risk-free rate over the 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

The Treynor ratio is calculated the same way as the Sharpe ratio but uses the investment's beta in the denominator. As with the Sharpe, 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 the fund earns more return per unit of systematic risk than Fund B.

Other Risk Adjustment Measures

Here are some of the other popular risk-adjustments:

• Alpha: An investment's return in relation to the return of a benchmark.
• Beta: An investment's return in relation to the overall market. The market is set at a beta of one—if the investment has a beta of more than one, it fluctuates more than the overall market. If it is less than one, it varies less than the market.
• Standard deviation: The volatility of an investment's returns relative to its average return, with greater standard deviations reflecting wider returns and narrower standard deviations implying more concentrated returns.
• R-squared: The percentage of an investment's performance that can be explained by the performance of an index.

Special Considerations

Risk avoidance is not always a good thing in investing, so be wary of overreacting to these numbers, especially if the measured timeline is short. In strong markets, a mutual fund with a lower risk than its benchmark can limit the real performance that the investor wants to see.

A fund that entertains more risk than its benchmark may experience better returns. In fact, it is common knowledge that higher-risk mutual funds may accrue greater losses during volatile periods, but they are also likely to outperform their benchmarks over full market cycles. 

The Bottom Line

Risk-adjusted return metrics are used by analysts to find out how much risk an asset has vs. a known low-risk investment. The 10-year Treasury is usually used as the risk-free rate, and various measurements are used to analyze risk. None of them are better than the other, but some are preferred over others.