What is Risk-Adjusted Return and Why Should You Care?
Risk-adjusted return measures an investment's return relative to the amount of risk taken. Two investments may have the same return, but the one with less volatility delivers a better risk-adjusted return. This metric helps investors make informed decisions by balancing risk and reward.
How to Calculate Risk-Adjusted Return
Here is the formula:
[\text{Risk-Adjusted Return} = \frac{R_{i} - R_{f}}{\sigma}]
Where:
- R_i is the investment return (as a percentage).
- R_f is the risk-free return (as a percentage).
- σ is the standard deviation of the investment return.
The result is a dimensionless ratio. A higher value means better return per unit of risk.
Calculation Example
An investment returned 8%, a risk-free bond returned 3%, and the standard deviation of the investment is 12%.
Calculate the excess return:
[\text{Excess Return} = 8 - 3 = 5]
Divide by the standard deviation:
[\text{Risk-Adjusted Return} = \frac{5}{12} \approx 0.4167]
The risk-adjusted return is approximately 0.4167, meaning the investment earns about 0.42 units of excess return for every unit of risk.