Every type of investment vehicle, whether it’s a mutual fund or exchange-traded fund (ETF), comes with a level of risk tied to it. Certain investors are able to tolerate a high degree of risk if they deem the return worthwhile. However, others prefer relatively safer investments that come with a fixed income stream, such as treasury savings bonds.
One way to determine if an investment has the potential to generate a profit is to calculate the risk-adjusted return, which evaluates the profit against the total risk within a particular time frame. When an individual has to compare two or more investments, using risk-adjusted returns could make it easier to decide which may perform better in the long term.
What Are Risk-Adjusted Returns?
Measured over a set period of time, a risk-adjusted return contrasts the conceivable profit that an investment may produce with the risk associated with it. In the context of investments, the definition of risk is the prospect that the real return on investment (ROI) could diverge from expectations. Investment vehicles generally have a better risk-adjusted return if they have a reduced degree of risk.
For example, an investor may anticipate that a corporate bond will reach its maturity date, which is when they can receive their principal repayment. However, this type of bond carries a credit risk where the corporation may default or end up bankrupt, ultimately impacting the value of the investment.
To decrease the chances of this scenario occurring, risk-adjusted returns come into play to provide an investor with insight into the projected ROI. Figuring out the risk-adjusted return may involve standard deviation or examining an investment’s data points throughout time. In the previously mentioned case, it could benefit an investor to do due diligence by researching the corporate bond issuer’s history of repayment.
How Can I Measure Risk in Investments?
There are several ways to determine a risk-adjusted return. Calculating risk-adjusted returns allows an investor to potentially make an informed decision on how to spend their resources. Note that the following is not an exhaustive list of the methods to measure risk-adjusted returns.
Sharpe Ratio
A common methodology in financial analysis involves the use of the Sharpe ratio, which takes its name from founder William Sharpe. Developing his namesake ratio in 1966, Sharpe would go on to work on the capital asset pricing model (CAPM) and eventually win the 1990’s Nobel Memorial Prize in Economic Sciences for his contributions.
This risk-adjusted return method looks at an investment’s profits on average and takes advantage of standard deviation. When weighing the pros and cons of two investments, the one with more potential to turn a profit usually correlates with a higher Sharpe ratio.
To complete the calculation of the Sharpe ratio, an investor has to have three values of an asset:
- The anticipated ROI
- The risk-free rate
- The return’s standard deviation
Typically the benchmark for a risk-free rate is the yield of a U.S. treasury bond. Calculate the Sharpe ratio by deducting the risk-free rate from the expected return, then dividing the resulting figure by the standard deviation. The investment is generally considered positive if the ratio is equal to or greater than one.
Jensen’s Alpha
Jensen’s alpha, which is also referred to as Jensen's measure, employs a market index as its baseline benchmark. Consequently, this is a method to figure out active ROI since it relies on movements in the market.
Unlike the Sharpe ratio, the formula for Jensen’s alpha requires knowing the value of the portfolio beta, which can measure volatility:
Jensen's alpha = D - [C + B(A - C)]
For this risk-adjusted return methodology, let D represent the anticipated ROI, while the risk-free rate is C. The letter B indicates the beta, and the value of the expected market return is A. If the alpha is higher than zero, then the return has outperformed the predicted outcome.
Treynor Ratio
Another way to evaluate risk-adjusted returns is by using the Treynor ratio, created by American economist Jack L. Treynor. The way to find the Treynor ratio is almost like calculating the Sharpe ratio, except instead of using the standard deviation, apply the portfolio beta.
As such, the formula involves subtracting the risk-free rate from the prospective return, then dividing by the beta. The higher the Treynor ratio, the better the likelihood of the financial asset generating a favorable return for an investor.
Why Is a Risk-Adjusted Return Important?
Using the Sharpe ratio, Jensen’s alpha, Treynor ratio, or another methodology to determine the risk-adjusted return gives an investor the advantage of understanding if the return might be worth the risk. It is a form of due diligence that empowers individuals with an educated guess about how their investment decisions could unfold over a span of time.
Risk-adjusted return methodologies do have their shortcomings, especially when unpredictable economic conditions affect markets, so relying on them exclusively is not advisable. They ideally should be referred to as a sort of guideline. After all, the old saying that knowledge is power could be applicable when it comes to particular investment vehicles.
Examples of Risk-Adjusted Return Methods
Sharpe Ratio
For example, consider Investment Portfolio X, which achieved a return of 8% over the past year with a standard deviation of 12%. Investment Portfolio Y, on the other hand, returned 6% with a standard deviation of 8%. Assuming a risk-free rate of 2% during the same period, the Sharpe ratios would be calculated as follows:
Investment Portfolio X: (8% - 2%) / 12% = 0.5
Investment Portfolio Y: (6% - 2%) / 8% = 0.5
In this case, both Investment Portfolio X and Investment Portfolio Y have the same Sharpe ratio of 0.5. Despite Portfolio X having a higher return, Portfolio Y achieves the same risk-adjusted return per unit of total risk, indicating it might be a more efficient use of risk-adjusted performance compared to Portfolio X.
Treynor ratio
The Treynor ratio is calculated the same way as the Sharpe ratio but uses the investment's beta in the denominator. Using the above example, lets’s calculate:
Since we don't have the beta of the portfolios explicitly provided, let's assume a beta of 1 for simplicity (which is often used as a benchmark for market risk).
For Investment Portfolio X:
- Return = 8%
- Risk-Free Rate = 2%
- Beta (assumed) = 1
Treynor Ratio for Portfolio X: [8% - 2%]/ 1 = 0.06
For Investment Portfolio Y:
- Return = 6%
- Risk-Free Rate = 2%
- Beta (assumed) = 1
Treynor Ratio for Portfolio Y: [6%-2%]/1 = 0.04
Therefore, based on the assumption of a beta of 1 for both portfolios, Investment Portfolio X has a higher Treynor ratio of 0.06 compared to Investment Portfolio Y, which has a Treynor ratio of 0.04. This indicates that Portfolio X provides a higher risk-adjusted return per unit of market risk (as measured by beta) compared to Portfolio Y.
Should I Avoid All Types of High-Risk Investments?
Whether or not you decide to invest in higher-risk investment vehicles, such as initial public offerings (IPOs), crowdfunding campaigns, or cryptocurrency, depends on your financial goals and risk tolerance.
For example, if your primary objective is to create a nest egg or emergency fund, risky investments could end up draining your resources, leaving you with limited capital to achieve your aims. This is where risk-adjusted returns can be useful to investors.
Additionally, risk tolerance may influence which investments you choose to put your money toward. The value of many cryptocurrencies, for instance, often fluctuates drastically, and certain investors potentially see this type of asset as too risky for their own portfolio. Take into account the case of Bitcoin.
On January 1, 2016, the price of Bitcoin on the market was around $435, reaching its peak only a few years later, in November 2021, when the value topped more than $65,000. Less than a year afterward, Bitcoin lost more than half of its market value. While bullish investors may hold onto their Bitcoin until the cryptocurrency surpasses its 2021 peak, others who are less optimistic may end up selling their crypto holdings.
How Do I Figure Out My Risk Tolerance?
Assess your financial goals and how long you expect it will take you to reach them, such as a maximum of five years down the line or perhaps even decades. Distinguishing between short-term and long-term goals and what they each involve could affect your monthly or weekly budgets and overall financial plans. When you make educated adjustments to your roadmap, the path to realizing your financial independence can become clearer.
There are also personal finance resources available online that offer risk tolerance assessments, which include questions about how you would invest hypothetical sums of money. Evaluating your risk tolerance allows you to better grasp the types of investments you are willing to make, opening your portfolio to broader horizons.
What Are Relatively Low-Risk Investments with a Good Return?
Financial experts consider U.S. treasury securities one of the safest investments, which are issued by the federal government in three forms: treasury bonds, treasury notes, and treasury bills. All three distribute interest on a semiannual basis, which usually results in a payout once every six months. However, each type of security has different maturity dates, which is when the bondholder is repaid the principal amount.
Another investment vehicle with a solid return is real estate bonds since real property backs their value. Industry-leading companies like Compound Banc make it easy for investors of any experience level to purchase real estate bonds. In fact, even an individual who has only begun to build out their investment portfolio can get started with Compound Banc’s user-friendly app that’s compatible with Apple and Android devices.
With just $10 per real estate bond, Compound Banc helps make investing accessible to the majority. Even better, every bond generates a 7 annual percentage yield (APY) compound return, creating a sustainable flow of income for an investor.
Join the Compound Banc community today to potentially grow your net worth and reach your financial goals.
Sources:
Bonds and Securities | U.S. Department of the Treasury
Population and sample standard deviation review (article) | Khan Academy
The Sharpe Ratio | Stanford University
Jensen's Measure | Investopedia
Portfolio beta Definition | Nasdaq
Assessing Your Risk Tolerance | Investor
Bitcoin price history 2013-2022 | Statista
Investment Risk Tolerance Assessment // Personal Financial Planning | University of Missouri
U.S. Treasury Securities | FINRA
Treynor Ratio Definition | Investopedia
William F. Sharpe | Wikipedia
