Risk-adjusted return is one of those rare investing terms that actually means what it says. It means that you take the gain or loss of an investment, and then adjust it for the risk taken. For example, if portfolio A earned a 12% return and portfolio B earned a 8% return, but portfolio A took twice as much risk as portfolio B, then portfolio B had a 8% risk-adjusted return, whereas portfolio A had a 6% risk-adjusted return. While it is commonplace for people to tend to look just at the gain or loss of their portfolio, or an individual investment, we should all focus on the risk-adjusted return, as it is the better measure of performance over the long-term.
There are multiple risk measures for investments, with two of the most popular being beta and standard deviation. Beta the tendancy of an investment’s price movement to be similar to or different than its market. A beta of 1 means that the investment moves exactly in lockstep with the market, whereas a beta of -1 means it moves exactly opposite (i.e., if the market goes up 1% in a day then the investment goes down 1%). A beta of 0 means that there is no correlation between the price movement of a security and its market. Betas don’t have to be -1, 0 or 1. They can be any number, and sometimes they are even well above 1. Most people are familiar with standard deviation, as it measures how spread out a set of data is from its mean, or average.
Three of the most common ways to measure risk adjusted return are alpha, Sharpe ratio and Treynor ratio. Alpha measures the performance of an investment that is not explained by beta. An alpha of 0 means that the investment performed as expected by its risk, or beta. An alpha greater than 0 means that the investment outperformed its risk, and an alpha less than 0 means that the investment underperformed its risk. In thinking about buy and hold versus more active strategies, especially in light of whether actual mutual funds can really outperform their indices in the long run, it is important to realize that it is uncommon for a portfolio to consistently generate alpha.
The Sharpe ratio and Treynor ratio both take the performance of an investment, then subtract the risk-free rate of return and divide the result by a measure of risk. For the Sharpe ratio the risk measure is standard deviation and for the Treynor ratio the risk measure is beta. The risk-free rate of return is often a government bond, such as the U.S. 3 month treasury bill, as the odds of the U.S. defaulting on that debt is essentially zero, and there is not much currency risk or inflation risk during that short of a time span.
In evaluating the performance of your portfolio, or of a particular investment of a portfolio, it is helpful to focus on one or more of alpha, Sharpe or Treynor, and to look over a longer period of time, preferably a full market cycle of 5-10 years. Someone moving in and out of asset classes may have a great return the past couple of years if they rode the success of the U.S. stock market, but when you look at their long-term performance and adjust it for the risk taken, they may significantly underperform a more diversified portfolio.