Risk-Adjusted Return
Candlefocus EditorRisk-adjusted return measurements offer investors certain benefits, such as allowing them to compare different investments of different risk levels. The most common risk-adjusted metrics are the Sharpe ratio and Treynor ratio. These measures of risk-adjusted performance help investors determine whether the reward from an investment outweighs the risk taken to generate the return.
The Sharpe ratio measures the expected return of an investment beyond that of a risk-free asset by dividing the investments excess return by its standard deviation. It expresses how much excess return an investor earns in relation to the risk taken on an investment. It will typically be shown as a number between 0 and 1, with a higher number indicating better risk-adjusted performance.
The Treynor ratio is similar to the Sharpe ratio, but it uses the beta of an investment in its calculations. Beta, commonly known as the volatility of an investment, is used to measure the technical risk of the investment. The Treynor ratio measures the expected return of an investment in relation to its technical risk, shown in terms of beta.
Risk-adjusted return measurements are helpful for investors when determining the risk-reward trade-off of an investment. Through the use of these measurements, investors can more accurately evaluate different investments, regardless of their risk levels. Knowing an investments risk-adjusted return allows an investor to compare different investments and to determine which one is more attractive and which one fits the investors risk tolerance profile better.
Risk-adjusted returns are important for investors, especially those with an appetite for higher risk investments. By using risk-adjusted metrics such as the Sharpe ratio or Treynor ratio, investors can make more informed decisions that can help them achieve the returns they desire without taking on too much risk.