The risks accompanying investment in stocks include the loss of principal. Therefore, most investors look for how to maximize return while minimizing the risk. However, determining how to evaluate these returns in terms of the actual risk taken is quite difficult. This is where the concept of risk-adjusted returns is crucial. Without a proper understanding of what risk-adjusted returns refer to, investment decisions may be misinformed and end in eventual financial loses.
Risk-adjusted return provides a measure of comparing the profit earned from an investment with the risks undertaken to get those returns. There are several methods by which to calculate risk-adjusted returns, each having different features and applications. One feature of comparison can be understood by understanding one’s investment strategy as performed relative to the risks one bears.
In the remainder of this article, we will describe five of the best ratios and formulas to measure the risk-adjusted return of an investment: the Sharpe Ratio, Sortino Ratio, Jensen Ratio, Treynor Ratio, and a simple comparison of the return measurement based on the dollars invested over time. All this will leave you armed with enough information to compare your investment plans using a more meaningful scale, thus making better investment decisions.
Measuring Risk in Investment
What is Risk?
Risk, as a term of investment, is simply the probability of losing money over a set period. Compare, for example, two scenarios of investment strategy: Investment A reliably has returns while Investment B shows the risk more comparable to a roller coaster. While both investments could have returns independently, identical or reasonably proximal to each other within one calendar year, investment A limits panic and loss potential, so it is more attractive to most investors .
Why Measure Risk
It is fundamental for any investor or trader to understand risk. High volatility can precipitate mistakes in behavior based on panic sales or investment in market frenzies based on fear of missing out, better known as FOMO. In this regard, it becomes crucial to measure returns adjusted for risk to determine exactly how much in terms of volatility the investor faces to acquire their returns, all of which is important to keep an investment discipline intact.
The Five Best Ratios for Evaluating Risk-Adjusted Returns
1. Sharpe Ratio
This ratio was named after the economist William Sharpe, who introduced it in the 1960s. Among all of the popular measures for risk-adjusted return, this measure is one of the most popular. It states the excess return an investment has over the risk-free rate per unit of risk undertaken.
Formula:
Sharpe Ratio = (Ri – Rf)/σ
Where:
Ri = Return of the investment
- R_f = Risk-free rate, like treasury yield
- σ = Standard deviation of returns on the investment
A Sharpe Ratio of greater than 1 is typically viewed as being very good, and values of over 1.5 are exceptional. For example, Jim Simons’ Medallion Fund has a Sharpe Ratio of 1.68 over the period from 1993-2005, that demonstrates exceptional risk-adjusted performance.
2. Sortino Ratio
The Sharpe Ratio variation which is meant to hold only the downward volatility came from Frank Sortino. It punishes just the downside risk since most investors react emotionally more towards losses than to gain.
Formula:
\text{Sortino Ratio} = \\frac{R_i – R_f}{DR} \\]
Where:
- DR = Downside risk, calculated as the standard deviation of negative returns
A Sortino Ratio of 2 or better is considered excellent. For instance, assuming that Fund H bears a higher return per unit of downside risk than Fund G, the number would reveal a preference for H over G.
3. Jensen Ratio (Jensen Alpha)
The Jensen Ratio, or Jensen Alpha, would then measure the performance of an investment against its expected return as defined by the CAPM. It, in short words, determines how much return has been achieved above or below the expected return given the risk.
Formule: \
\\[ \\text{Jensen Alpha} = R_i – [R_f + \\beta(R_m – R_f)] \\]
Where: \
- \\( R_i \\) = Actual return of the investment
- \( R_f \) = Risk-free rate
- \( β \) = Beta of the investment (measure of systematic risk)
- \( R_m \) = Return of the market
A positive Jensen Alpha indicates that an investment outperformed against the expected return, whereas a negative value would indicate underperformance. For example, if the return of a mutual fund was 16%, when compared with the return of the market index at 10%, and having a beta of 1.4, and with a risk-free rate of 2%, in that case, the Jensen Alpha is 2.8, which indicates good risk-adjusted performance.
4. Treynor Ratio
Developed by Jack Treynor, the Treynor Ratio measures return earned in excess of the risk-free return per unit of market risk, represented by beta.
Formula: Treynor Ratio = [R_i−R_f]/β ]
The higher the values, the better the risk-adjusted performance. For example, if Fund C has a lower return than Funds A and B but the beta is low, then the Treynor Ratio may still indicate that C presents a better risk-adjusted return.
5. Time-Weighted Return
Time-weighted return measures returns in relation to the time actually invested in the market. This makes it an excellent tool for short-term traders.
Formula:
[\text{Risk Adjusted Return} = \frac{\text{Annual Return}}{\text{Time Invested}} ]
For instance, if an investment strategy generates an annual return of 10% but only spends half its time active in the market, then its risk-adjusted return is 20%. In essence, it gives intuitive insights to the value accrued from obtaining returns on fewer hours at risk in the marketplace.
Conclusion
For any investor looking to optimize the performance of his or her portfolio, understanding the concept of risk-adjusted returns is essential. The five ratios outlined include the Sharpe Ratio, Sortino Ratio, Jensen Ratio, Treynor Ratio, and time-weighted return, which can lead to insights from which investments can be criticized regarding the level of risks undertaken.
The metrics will become a far more reliable factor for investors to consider in determining their investment strategies to guard against the market’s complexities, allowing them to make better decisions according to their risk tolerances and relevant goals. In other words, it’s still all about the need for maximum return on investments with the lowest possible amount of risk involved. And with that said, you can now tackle your approach to investment strategy much better and with greater certainty and peace of mind.