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Quantifying Risk-Adjusted Returns

In this day and age, most regular folk know that investing is a good idea. They just may not have the funds necessary to make money and create wealth for themselves, and many of those that do lack the knowledge required on how to guide this process adequately. They do not grasp the basic principles of the investment process that open the doors for quality trading decisions.

Investing is something that can yield terrific long-term rewards, potentially setting up individuals for retirement. However, in a time where most people in their twenties and thirties are very risk-averse, per multiple polls, the procedure should come with the understanding that the fruits of this endeavor are to come two to three decades down the road. Moreover, to reap them, one must know how to navigate investment waters and know that risk-adjusted returns are one of the most vital elements to successful long-term trading, albeit an overlooked and usually misunderstood one by newbie investors.

What is a risk-adjusted return, and how does one quantify one? Well, this is a calculation, often presented as a ratio of the return, or a potential return, on an investment such as a corporate bond or stock when compared to equivalents or cash. Know that higher readings of this ratio are customarily considered more desirable and healthier. Various formulas exist to come up with accurate risk-adjusted return readings, and these get explained below, along with multiple other aspects connected to this ratio.

Understanding Risk & Return

In most people’s eyes, the basis of investing lies in the risk-return tradeoff. That defines the probability of success, meaning the odds in play in this process. Explained in the simplest turns possible, risk in trading gets defined as the probability of someone losing their invested funds. Return, on the other hand, as a concept, is the change in value an asset notches over time. A negative one is a loss, and positive returns get marked as a profit.

Everyone should know their risk tolerance before engaging in any trading practice. That refers to the amount of risk they are willing to accumulate en route to seeking wealth accumulation. In principle, low levels of risk get associated with modest potential returns, while high ones usually can bring substantial profits.

Experts divide risk into three principal categories. They are market, liquidity, and credit risk. The first group divides into four sub-tiers, interest, inflation, currency, and volatility risk.

Investors consider the risk-return tradeoff across their portfolio and individual investments before making decisions regarding them. The optimal tradeoff gets determined by various different gauges. As a rule of thumb, the top three are the mentioned risk tolerance one is willing to endure, the investing timeframe, and the ability of the investor to continuously replenish lost funds/assets.

Common Measures of Risk-Adjusted Returns

As mentioned in the intro, when measuring investment returns, different methods can get used. The most popular are the following three ratios, the Sharpe, the Treynor, and the Sortino. To these, Jensen’s Alpha can get added as it is another highly-established pick serving this purpose.

The Sharpe, probably the most famous of these four measures, divides excess returns by volatility (the standard deviation), which features its somewhat complex formula. Excess returns are ones above the risk-free rate of return or a standard sector benchmark, and when calculating the Sharpe ratio, individuals may use historical info. The inherent drawback of this approach that many investors point out is that it gets overstated in some investment tactics and that it can get manipulated to display a higher risk-adjusted returns history by extending measurement intervals. By doing so, they can diminish projected volatility.

The Sortino ratio gets viewed as analogous to the Sharpe, ranking as its variant. It differentiates dangerous volatility from the overall one via a security’s standard deviation of negative returns. Named after the founder and Director of The Pension Research Institute, Frank Sortino, it improves the Sharpe ratio by not punishing the investment for good risk.

If someone wants to know the amount of excess return that got generated for every unit of risk in an investment or a portfolio, then the Treynor ratio is the performance metric to use. It also gets called the reward-to-volatility measure and is similar to the Sharpe, as it takes the return and removes the risk-free rate from it, dividing that by the beta. A higher Treynor ratio indicates a more appropriate investment, and for the uninformed readers out there, the beta is a coefficient that assesses the volatility relative to the market. Often, its backward-looking nature gets highlighted as its primary weakness. Another con is that its accuracy depends on utilizing highly suitable benchmarks to measure the beta coefficient.

The formula for Jensen’s Alpha, the last discussed tool to measure risk-adjusted returns, is Portfolio return – [risk-free rate (RFR) + Beta * (market return – RFR)]. It shows the difference in a person’s returns vs. the market, representing the average return on an investment/portfolio. Its disadvantages lie in that it utilizes an individual factor model (CAPM – the capital asset pricing model) and does not factor in unsystematic risk. The difference between it and the Treynor ratio is that the latter uses the Beta coefficient for its calculation despite the pair both being based on systematic risk. 

Calculating Risk-Adjusted Returns

We explained how to calculate risk-adjusted returns in four different ways above. Now, let us provide an example of going through the process using the most renowned formula of the four cited, the Sharpe ratio.

Again, it gets calculated by removing the risk-free rate from the return of a portfolio and dividing the attained figure by the standard deviation of its excess returns. Let us say that we wish to invest in a fictional stock in a company – Global Trade. That is a made-up entity that has returned a 15% annual average in the past five years. The risk-free investment in our scenario will be a 0.4% interest rate US treasury security, and the volatility or standard deviation of Global Trade is 20%. Hence, our Sharpe ratio would amount to 0.73 because (15% – 0.3%) / 20% equals 0.73.

Now, is this a decent Sharpe ratio? No. Why? Because generally speaking, everything below one gets viewed as sub-optimal. The ratio should be between one and two to get a good rating. A ratio falling between two and three is very good, and anything higher than three is terrific, by all accounts.

Evaluating Investment Performance Based on Risk-Adjusted Returns

One more time, risk-adjusted returns display the profits specific investments have made relative to their incurred risks throughout a period. Therefore, if multiple trades show identical returns over a specific timeframe, the one with the lowest risk will feature the best risk-adjusted return of the bunch.

The majority of investors make the mistake of putting too much emphasis on returns in their elementary form without considering the hazards investments get exposed to achieving them. Nevertheless, it is also essential that no one over-reacts to the numbers/ratios the discussed formula supply, particularly if they are measuring these returns in the short term. Though, when it comes to mutual funds, ones that entertain more risk than their benchmark may supply better returns, while a fund with a lower risk can limit the type of performance investors like to see. A common criterion many tend to follow is that mutual funds can outperform their benchmarks.

Remember that the chief aim of risk-adjusted returns relating to securities for most veteran investors is to compare individual stocks, mutual funds, or whole investor portfolios. That is all.

Limitations of Risk-Adjusted Returns

There are no outright drastic limits to risk-adjusted returns sans inaccurately calculating them and getting false data. They are nothing other than the outcome of measurement techniques that deliver information that helps individuals make decisions. People invest as a means to build riches. And the main obstacle always standing in the way of this goal is the underlying risk their trades carry. Naturally, having more information at one’s disposal means that more educated, higher-quality choices can get made.

Risk aside, the liquidity factor also substantially affects investing decisions. A high one specifies that a given security is hard to buy or sell. That can be due to an issuing company’s liabilities being difficult to satisfy because of lowered cash flow. The liquidity factor can be a market one, meaning systematic risk connected to market volatility, or a funding one, relating to an entity’s intrinsic values, its capacity to manage operating cash flows and pay off short-term debt.

There is also the somewhat rarely highlighted uniformity factor, looking at a security’s ability to continuously surpass its set targets, generating returns above its benchmark. The returns factor checks for stable past performances, and the research one prioritizes learning about security as much as possible before pouring money into it.

Of course, market conditions, trends, geo-political stability, and the industrial/economic state of a region/sector also play massive roles in anyone’s investment decisions. That shows that people need to have a big-picture view when trading anything.

The Wrap Up

Risk is something that is ever-present in life, and it is one of the most crucial elements in the investment process. Everyone wants to know the profitability of their trades. But to see the value of the generated investment numbers properly, it is best to take into account the level of risk acceptable to reach the in-the-black figures. That is where risk-adjusted returns come in, usually calculated using the Sharpe, Sortino, and Treynor ratios plus Jensen’s Alpha. Each of these yields a slightly different result, but all are acceptable and commonly-used methods for this purpose.

Without question, risk-adjusted returns aid investors in figuring out if the risk accrued was well worth the attained or expected price. Some analysts like to compare this concept to a car’s speed limit. The more it goes above a specific number, the more the probability of getting to your desired point grows. But that also increases the likelihood of crashing. That same goes for risk-adjusted return.

The safest approach to investing is a slow-and-steady mode, where one builds a diversified portfolio based on one’s risk tolerance and set aims, disregarding reactive tendencies and rebalancing parodically. That is undoubtedly the best way to financial stability and the safest route to a secure retirement, with a low risk of experiencing an investing accident along the way.

Additional Resources

–        Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns – John C.Bogle, 2007

–        Managing Downside Risk in Financial Markets – Frank Sortino, 2001

–        The Sortino Framework for Constructing Portfolios – Frank Sortino, 2009

–        Portfolio Theory and Capital Markets – William F.Sharpe, 1970

–        Treynor On Institutional Investing – Jack L.Treynor, 2007

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