Risk Adjusted Returns

A risk-adjusted return measures investment profit, accounting for the level of risk taken to achieve it. It compares the investment's risk to a virtually risk-free investment, providing a clearer picture of performance by factoring in the inherent risk.
EXPLORE FUNDS
Risk Adjusted Returns
EXPLORE FUNDS
3 min
17-September-2024
Risk-adjusted returns are a crucial measure in the world of finance, helping investors evaluate the profitability of an investment relative to its risk. Essentially, this metric allows us to see how much return an investment has generated per unit of risk taken. For instance, two investments might both yield a 10% return, but if one carries higher risk than the other, its risk-adjusted return will be lower. By considering the risk involved, investors can make more informed decisions and choose investments that provide the best balance between risk and reward.

In this article, we will understand risk adjusted returns meaning, what are risk adjusted returns, risk adjusted returns formula and risk adjusted returns calculation.

What is a risk-adjusted return?

A risk-adjusted return is a measure that evaluates the profitability of an investment relative to its risk. It allows investors to compare the returns of various investments, considering the level of risk each entails. By focusing on risk-adjusted returns, investors can make more informed decisions, aiming for higher returns with manageable risk levels.

Factors affecting risk-adjusted mutual fund returns

Several factors influence the risk-adjusted returns of mutual fund schemes, including asset allocation, volatility, fund management, and benchmark performance.

Asset Allocation

Asset allocation refers to how a fund's investments are distributed across different asset classes, such as stocks, bonds, and cash. Proper diversification can help manage risk and improve risk-adjusted returns by balancing potential losses in one asset class with gains in another.

Volatility

Volatility measures the price fluctuations of a mutual fund over time. Higher volatility indicates higher risk, which can impact the fund's risk-adjusted returns. Investors typically seek funds with lower volatility to achieve more stable returns.

Fund management

The expertise and strategy of the fund manager play a crucial role in determining the risk-adjusted returns of a mutual fund. A skilled manager can identify opportunities and mitigate risks, thereby enhancing the fund's performance relative to its risk.

Benchmark

A benchmark is a standard against which the performance of a mutual fund is measured. Comparing a fund's returns to a relevant benchmark helps investors understand how well the fund is performing in relation to the market and assess its risk-adjusted returns.

How to assess risk-adjusted returns in mutual funds?

To evaluate the risk-adjusted returns of mutual funds, investors can use various metrics like alpha, beta, and standard deviation.

Alpha

Alpha measures a fund's performance relative to its benchmark. A positive alpha indicates the fund has outperformed the benchmark, while a negative alpha suggests underperformance. Alpha helps investors understand the value added by the fund manager's investment decisions.

Beta

Beta assesses a fund's volatility in relation to the market. A beta greater than 1 indicates higher volatility than the market, while a beta less than 1 indicates lower volatility. Understanding beta helps investors gauge the risk level associated with a fund.

Standard deviation

Standard deviation quantifies the dispersion of a fund's returns from its mean. A higher standard deviation indicates greater variability and risk. Investors use this metric to assess the consistency of a fund's performance and its risk-adjusted returns.

Calculation and interpretation of risk-adjusted returns

Risk-adjusted returns are calculated using various metrics, such as the Sharpe Ratio, Treynor Ratio, and Sortino Ratio. In the risk adjusted returns formula, each of these ratios measures the return of an investment relative to the risk taken to achieve it. By comparing these ratios, investors can interpret how well an investment compensates for its risk level and make informed decisions to balance potential gains with manageable risks.

  • Sharpe ratio: Measures the excess return per unit of standard deviation.
  • Treynor ratio: Treynor ratio evaluates returns relative to systematic risk (beta).
  • Sortino ratio: Sortino ratio focuses on downside risk, considering only negative volatility.

Why consider risk before investing?

Considering risk before investing is essential for making informed decisions, protecting your capital, and achieving long-term financial goals. It helps investors select the right investments, evaluate fund manager performance, and ensure peace of mind.

Select the right investments

Understanding risk enables investors to choose investments that align with their risk tolerance and financial objectives. By assessing potential risks and returns, investors can build a diversified portfolio that balances growth and stability.

Evaluate fund manager/financial advisor performance

Evaluating the performance of fund managers and financial advisors based on risk-adjusted returns ensures that they are effectively managing risks while seeking optimal returns. This helps investors identify skilled professionals who can deliver consistent performance.

Peace of mind

Investing with an understanding of risk provides peace of mind, knowing that your investment decisions are based on a thorough evaluation of potential risks and rewards. This confidence helps investors stay committed to their long-term financial plans, even during market fluctuations.

Using risk-adjusted return to analyse your investments

Risk-adjusted returns provide a comprehensive view of an investment's performance, considering both returns and associated risks. By analysing these metrics, investors can identify high-performing investments that align with their risk tolerance, helping them optimise their portfolios for better risk management and enhanced returns.

What makes a good risk-adjusted return?

A good risk-adjusted return indicates that an investment has provided substantial returns relative to the risk taken. This can be evaluated using various ratios:

  • Sharpe ratio: A higher Sharpe Ratio suggests that an investment has generated more excess return per unit of risk. Typically, a Sharpe Ratio above 1 is considered good, above 2 is very good, and above 3 is excellent.
  • Treynor ratio: A high Treynor Ratio indicates that an investment has delivered returns well in excess of the risk-free rate, considering its market risk (beta). A positive Treynor Ratio is generally favourable.
  • Sortino ratio: A higher Sortino Ratio signifies that an investment has produced higher returns relative to the downside risk. This ratio is particularly useful for investors who are more concerned about negative volatility.
Ultimately, a good risk-adjusted return reflects a well-managed investment that balances risk and reward effectively. Investors should consider these metrics along with their financial goals and risk tolerance to determine what constitutes a good risk-adjusted return for their specific situation.

Key takeaways

  • Risk-adjusted return measures how much return an investment provides after accounting for the risk taken.
  • There are various methods to evaluate this, including the Sharpe Ratio, Treynor Ratio, alpha, beta, and standard deviation, each offering a unique perspective.
  • Investors use risk-adjusted returns to assess if the potential reward justifies the risk involved.

Conclusion

Understanding and analysing risk-adjusted returns is essential for making informed investment decisions. By considering both returns and the risks taken to achieve them, investors can better evaluate their investments and ensure they align with their financial goals. Utilising metrics like the Sharpe Ratio, Treynor Ratio, alpha, beta, and standard deviation allows for a comprehensive assessment of an investment's performance while investing in mutual funds. The Bajaj Finserv Platform offers a robust selection of over 1000+ mutual funds, helping investors find options that provide favourable risk-adjusted returns along with the option to compare mutual funds. This approach aids in building a balanced and diversified portfolio, ultimately leading to better financial outcomes.

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Frequently asked questions

What is meant by risk-adjusted returns?
Risk-adjusted returns measure an investment's return relative to its risk. This metric helps investors assess if the potential reward justifies the risk taken, providing a more comprehensive evaluation than simple returns.

What are the 4 risk-adjusted return measures?
  • Sharpe ratio: Excess return per unit of total risk.
  • Treynor ratio: Return relative to market risk (beta).
  • Alpha: Return beyond the benchmark index.
  • Sortino ratio: Return per unit of downside risk.
Is a high risk-adjusted return good?
Yes, a high risk-adjusted return is favourable. It indicates that an investment has provided better returns relative to the risk taken, reflecting effective risk management and desirable investment performance.

What are the benefits of risk-adjusted returns?
Benefits include improved investment comparison, better decision-making, effective portfolio management, and increased awareness of risk relative to return.

What is a good risk-adjusted return ratio?
  • Sharpe ratio: Above 1 is good; above 2 is very good.
  • Treynor ratio: Positive values indicate effective performance.
  • Sortino ratio: Higher values reflect better returns relative to downside risk.
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Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed.

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