What Is a Risk Adjusted Return?
A risk adjusted yield is the calculation of the returnor potential return of an investment that is based on the level of risk that has to be accepted to attain it. The risk is assessed by comparison to an investment that is virtually risk-free, typically U.S. Treasuries.
Depending on the method utilized depending on the method used, according to the methodology used method used for risk calculation is presented in terms of a number or rating. Risk-adjusted return calculations are applied to individual investments, stocks, as well as to complete portfolios.
Understanding Risk Adjusted Return
The risk-adjusted returns measure the amount of profit you have achieved in relation to the risk it has taken on over a certain amount of time. If more than one investments have produced the identical returns during a specific time frame that investment with the lowest risk will receive an increased risk-adjusted yield.
The most commonly used risk indicators to evaluate investments include the alpha, beta, R-squared, standard deviation, and Sharpe ratio. In looking at two or more possible investment options, investors should utilize the identical risk gauge for each investment in consideration to gain an idea of the relative performance.
Examples of Risk Adjusted Return Methods
Sharpe Ratio
Sharpe ratio Sharpe ratio determines the amount of profit earned by an investment which is higher than its Risk-Free rate per standard deviation unit. It is calculated by taking the profit of the investment and subtracting the risk-free percentage and then dividing the amount by the value of investment’s HTML0standard deviation.
In all other respects an increase in the Sharpe ratio is more beneficial. Its average deviation indicates the return volatility of an investment in relation to its average return with higher standard deviations indicating higher returns, and smaller standard deviations meaning higher returns. The risk-free rate utilized can be described as an indication of the yield on a non-risk investment, like an Treasury bond (T-bond) for the applicable duration of.
As an example, suppose that Mutual Fund A returned 12 percent in the past year, and had a standard variance of 10 percent. Mutual Fund B returns 10 percent and has a standard variance of 7.7% and the risk-free rate for the entire period was 3percent. Sharpe ratios are calculated as follows: Sharpe ratios can be calculated in the following manner:
- Mutual Fund A: (12% – 3%) / 10% = 0.9
- Mutual Fund B: (10% – 3%) / 7% = 1
While Mutual Fund A had a greater returns, Mutual Fund B had the highest risk-adjusted returns which means that it earned greater per unit risk than Mutual Fund A.
Treynor Ratio
It is the Treynor ratio is calculated in the same way as the Sharpe but it incorporates the investor’s beta in the denominator. Similar to Sharpe, when calculating the Sharpe ratio, a greater Treynor ratio is more beneficial.
Utilizing the example of the previous fund as a reference, and taking into account that each fund have beta of 0.75 The calculations are as below:
- Mutual Fund A: (12% – 3%) / 0.75 = 0.12
- Mutual Fund B: (10% – 3%) / 0.75 = 0.09
In this case, Mutual Fund A has an increased Treynor ratio, which means that the fund earns more returns for each unit systematic risk than Fund B.
Special Considerations
The tendency to avoid risk is not always a good thing when the investment world, therefore be cautious of reacting too quickly at these statistics, particularly when the timeframe being measured is not long. If the market is strong the use of the use of a mutual fund that has less risks than the benchmark will limit the actual performance the investor would like to observe.
A fund that is higher danger than the fund it is compared to might be able to earn higher returns. In actual fact it has been proven numerous times that higher risk mutual funds could suffer more losses in turbulent times, but they will also outperform their peers over the all cycle of market.
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