Usually, most people get told to invest in the stock market as a tool to build wealth for retirement and ensure their financial stability in the long term. However, purchasing shares in publicly-traded business entities also contributes to the growth and development of the economy as a whole. And it can support companies that promote social responsibility, diversity, and inclusion. So, there can be a philanthropic take on the endeavor on top of the motivation to build generational wealth.
It is clear that the benefits of this practice (trading securities) are multiple. And one of its most essential steps is investment performance reporting, or in other words, gauging the well-being of held assets. The importance of this is multifold. First, it helps traders identify the risk level associated with potential investments, both currently and going forward, which assists them in making informed decisions about their financial future. Measuring investment performance is also crucial for accountability as it lets investors be held liable for the results of their trading activity, which they can assess through benchmarking using market indexes and evaluating generated returns.
Without question, calculating risk-adjusted returns is one of the top measurements of an investment’s performance, meaning its health. It gets utilized to compare the performance of trades with varying levels of incurred market hazard. There are multiple ways to accomplish this. Hence, to learn more about the most popular ones and the definition of this assessment criteria, check out the subheadings that follow.
Understanding Risk-Adjusted Returns
In finance, the term return refers to the loss or profit created by an investment over time, often expressed as a percentage of the initial investment. Most experts would say that there are four types. The total return is the summed-up profit/loss, including income and capital gains. The annualized is the average rate of return earned over a year. Net returns are notched after an investor deducts all his expenses, such as taxes and fees, and the gross ones get viewed before this procedure occurs.
Looking at generated returns is vital to appraise the state of one’s assets, as they are a terrifically objective way of evaluating the success of trades made and an instrument that tells investors where they should hold or sell their assets, and how to adjust their portfolio en route to hitting their financial goals.
Risk-adjusted returns, explained in the simplest way possible, are the returns a trader receives over the sum that they could have attained by investing in a risk-free asset, such as a US Treasury bond, adjusted for the risk level taken. The risk level customarily gets measured by the volatility or variance of an investment, which is the sum of its price fluctuation over a given period. Thus, it is an indispensable concept/apparatus in investment analysis, allowing investors to compare the returns of different assets with varying risk levels. It is routinely featured in most stock tracking apps, under the performance report function, in the return sections of this software.
Popular Ways to Calculate Risk-Adjusted Returns
There is no one-size-fits-all method for calculating risk-adjusted returns. Specific techniques can and are more appropriate for different types of assets and investment tactics. Therefore, it is fundamental to carefully consider which approach one uses, depending on the characteristics in play.
Here we will look at the four most established methods investors can implement to learn about their risk-adjusted returns. Some are more suitable for investments correlating to the overall market, others for actively-managed trades, and some for ones with skewed or fat-tailed returns.
Sharpe Ratio
The Sharpe ratio informs those trading securities just how much excess return they are raking in above the risk-free rate per risk unit. It gets calculated by subtracting the risk-free rate of return from the rate of return, then dividing that outcome by the standard deviation of the investment’s returns. That means that the formula for this ratio is = (return – risk-free rate) / standard deviation. Given this, if an investor poured money into a mutual fund with an annual return of 12%, a risk-free rate of 3%, with the standard deviation of the fund’s returns over the past year being 15%. Then the Sharpe Ratio for this mutual fund would be 0.6, meaning that for every risk unit accrued, this fund created 0.6 units of excess return over the risk-free rate.
Treynor Ratio
The Treynor ratio gives us an idea of the excess return an investor takes home per accumulated unit of systematic risk. It gets calculated by removing the risk-free rate of return from the rate of return and dividing that produced outcome by the beta. What is the beta? It is a measurement of an investment’s return sensitivity compared to the overall market. In short, it indicates the systematic risk strain an investment bares. To discover it, one must gather data on the investment’s returns and those of a market benchmark. Traders can then use regression analysis to figure out the slope of the relationship between these, with the line slope representing the beta.
The Treynor ratio for a mutual fund with a 15% annual return, a risk-free rate of 3%, and a beta of 1.2 would be 10%. Accordingly, the fund created an excess return of 10% for every taken systematic risk unit.
Sortino Ratio
Named after its creator, Frank A. Sortino, this measure of assessing risk-adjusted performance is super similar to the previously discussed two. But it considers downside risk, which makes it handy for apprising trades where minimizing downside risk is vital, like hedge funds. The formula here is subtracting the target rate of return or the minimum acceptable return from the average annual return and dividing that by the standard deviation of negative returns.
To come up with the Sortino Ratio for a mutual fund, one must first calculate the downside deviation. That happens by determining the minimum acceptable return, the threshold under which returns get ranked as negative (losses). The downside deviation gets generated using this formula – D = sqrt(sum of (Ri – T)^2 / number of negative returns). Here Ri is the return for each period, and T is the acceptable minimum return. Note that the total of (Ri – T)^2 gets taken just for timeframes where Ri is less than T, and the figure of negative returns is the sum of intervals where Ri is less than T.
Again, the formula for the Sortino Ratio is (Rp – Rm) / Dd, meaning Rp is the portfolio’s average return, RM is the minimum acceptable return, and Dd is the downside deviation.
Jensen’s Alpha
Also called the alpha coefficient, Jensen’s Alpha gets calculated by taking out the expected return of an investment (usually determined by CAPM, the capital asset pricing model) from its actual return and adjusting that difference for the systematic risk level via the beta. A negative alpha is an indicator of underperformance, and a positive is one of outperforming.
Here is an example of getting Jensen’s Alpha using distinct figures. Let us do it. So, someone has invested in a mutual fund with an expected return of 8%, determined by the CAPM, benchmarked against the S&P 500, whose return is 9%. The actual return of the mutual fund is 10%. And its risk-free rate is 2%, with a beta of 1.2. To get the alpha, we must first come up with the fund’s expected return based on its systematic risk level using this formula = Risk-Free Rate + Beta x (Market Return – Risk-Free Rate), which in this case would be 2% + 1.2 x (9% – 2%), resulting in 10.4%. Then we can figure out the excess return by subtracting the expected return (10.4%) from the actual one (10%), getting –0.4%. Lastly, we can incorporate the following formula – Excess Return – (Beta x Market Risk Premium), to conclude Jensen’s Alpha, which is -8% here.
Special Consideration
While risk plays a dramatic role in the investment process, avoiding it is not always positive. It is essential that no one overreacts to the figures generated by the methods rattled off above, especially if the considered period is not extensive. As a rule of thumb, a fund that entertains higher levels of risk than its benchmark can traditionally generate better returns. History has shown that higher-risk mutual funds may incur substantial losses in periods of volatility. Yet, over entire market cycles, they regularly outperform their benchmarks.
To Sum Up
In most investors’ eyes, calculating risk-adjusted returns is mandatory, as it tells them how much they earn from assets held to the risk they are taking for investing in said securities. That aids them in adjusting their trading strategy properly. So they can get the most bang for their buck.
Multiple methods exist for tallying risk-adjusted returns, stretching beyond the four listed above. Nevertheless, for casual investors (one’s unfamiliar with advanced financial metrics), the Sharpe ratio is likely the best selection. It indicates the excess return earned per accumulated risk unit. Veteran investors also like to incorporate the Sortino ratio, as it factors in the downside risk, which many see as vital. But, what tool anyone picks primarily depends on their risk tolerance, investment goals, and individual preferences.