What it means
A raw return only tells half the story. A fund that earned 10% by swinging wildly is not equivalent to one that earned 10% steadily, because the first exposed the investor to far bigger potential losses.
Risk-adjusted return puts the return and the risk side by side. Several measures fall under this heading.
The Sharpe ratio divides excess return by volatility (how much the return bounces around), the Treynor ratio uses sensitivity to the overall market instead, and the Sortino ratio counts only downside swings. Which one to use depends on what kind of risk matters most to the decision maker.
In business, RAR matters for comparing projects, funds, divisions and even salespeople on a like-for-like basis. A product line with a high profit but wildly uncertain demand may be less attractive than a smaller but steadier one.
Boards that reward managers on raw returns alone often encourage excessive risk-taking. The most widely used version compares the return above a risk-free rate, such as the yield on very safe government bills, with the standard deviation of the investment's returns.
The result is the extra reward earned per unit of risk taken. A higher number is better, and a negative number means the investment did worse than the safe alternative.
The nuance is that every risk measure rests on assumptions. Past volatility may not predict future volatility, and standard deviation treats upside surprises as risk even though investors welcome them.
Treat the figure as a useful comparison tool rather than a precise truth. Time period matters too, because a ratio built from one calm year can look excellent and then collapse in a turbulent one.
Practitioners therefore prefer to measure over several years and across different market conditions. A measure based on three years of monthly data is usually more reliable than one based on three months.
In practice
Real-world examples.
Example
A pension committee compares two fund managers who both beat the market by 3% a year. One did so with large swings and the other with smooth, steady gains. The committee prefers the steadier manager once returns are adjusted for risk.
Example
A company considers two investment projects with the same expected profit of $400,000. One depends on a single customer while the other depends on many. The finance team ranks the diversified project higher because its outcomes vary far less.
Example
A private bank assesses its advisers by the return their client portfolios earned relative to the risk those portfolios carried. An adviser who beat the average return only by loading clients into concentrated bets is flagged. The bank adjusts bonuses to reflect risk taken as well as profit earned.
Formula
Calculation
Sharpe ratio = (portfolio return - risk-free rate) / standard deviation of portfolio returns
Portfolio A earned 10% a year with a standard deviation of 16%, and the risk-free rate is 2%. Its ratio is (10 - 2) / 16 = 8 / 16 = 0.50. Portfolio B earned a lower 8% with a standard deviation of only 8%, so its ratio is (8 - 2) / 8 = 6 / 8 = 0.75. Although Portfolio A earned more, Portfolio B delivered more return for each unit of risk taken.Case study
Seen in the real world.
Ashdown Capital Group is an illustrative, fictional investment boutique whose bonus pool rewarded the highest raw return. One portfolio manager consistently led the table, but the risk committee noticed that his portfolios swung up and down by more than twice the range of his peers.
When the committee recalculated performance as risk-adjusted return, his ratio of 0.40 was below the peer average of 0.65. The peers' calmer portfolios had delivered more return per unit of risk.
The firm changed its bonus formula to include a risk-adjusted measure, and the aggressive manager moderated his approach. Over the following year, the average portfolio volatility at the firm fell and client complaints about large drawdowns eased. The illustrative point is that rewarding raw returns invites risk, while rewarding risk-adjusted returns rewards skill.
Watch out
Common mistakes.
- Comparing raw returns across investments with very different levels of risk.
- Treating one risk-adjusted measure as definitive, when different measures can rank the same investments differently.
- Relying on a short history of returns, which can give a misleading estimate of volatility.
Questions
People also ask.
What is a good risk-adjusted return?
There is no universal threshold, but a higher figure is better, and many practitioners regard a Sharpe ratio above 1.0 as strong while stressing that it depends on the asset class.
Can the figure be negative?
Yes, if the return is below the risk-free rate, the investment has earned less than a safe alternative even before adjusting for risk.
Which risk measure should I use?
Standard deviation is the most common, but if downside losses matter most, a downside-only measure such as the Sortino ratio may be more useful.
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