People often ask me if a certain investment is “good.” While it might seem like a simple question, there are different ways to look at it:
- Risk-Adjusted Return
- Values-Adjusted Return
- Tax-Adjusted Return
- Fee-Adjusted Return
- Stress-Adjusted Return
This article is the first part of a five-part series. I’ll go over each of these concepts in greater detail, starting with risk-adjusted returns.
What Are Risk-Adjusted Returns?
When investing, it’s crucial to understand risk-adjusted returns. It’s easy to get excited about investments with high returns, but if you don’t consider the risks, you could end up with big losses and stress. From the perspective of both academics and financial experts, risk-adjusted returns are the best way to look at investments. This approach helps balance how much you could earn with how much risk you’re taking to get there.
Risk-adjusted returns measure how much return (or profit) you’re making compared to the risk you’re taking. It’s not just about how much you earn—it’s about how much risk you have to go through to get that return. For example, two investors might both make 10% returns, but if one took on a lot more risk, their risk-adjusted returns are very different.
One of the most common ways to measure risk-adjusted returns is the Sharpe Ratio. This ratio tells you how much “extra” return you’re getting for every unit of risk. A higher Sharpe ratio means a better return for the level of risk you’re taking.
Why Do Risk-Adjusted Returns Matter?
If you only look at the raw returns (the simple profit you make), you might get a wrong impression. A high return looks attractive, but if it’s linked with a lot of risk, you could lose more than you gain. Risk-adjusted returns give a clearer picture by showing whether the return justifies the risk.
For example, imagine comparing two investments:
- Investment A: 10% return, Sharpe ratio of 0.5
- Investment B: 8% return, Sharpe ratio of 1.0
While Investment A has a higher return, Investment B offers a better return for the risk taken. In this case, Investment B is actually the smarter choice based on risk-adjusted returns.
How to Evaluate Risk-Adjusted Returns
1. Know Your Risk Tolerance or Need: Before looking at any investments, figure out how comfortable you are with risk. Can you handle lots of ups and downs for higher returns, or would you rather play it safe? Your risk tolerance will help you choose investments that match your comfort level and goals.
2. Compare Investments Fairly: Don’t just look at the raw returns—look at the risk-adjusted returns. This gives you a more accurate view of how well the investment is performing compared to its risk.
3. Consider the Time Frame: Risk-adjusted returns can change over time. An investment might look great over a long period (like 10 years) but have had some bumps recently. Make sure you’re looking at the right time frame for your goals.
4. Look Beyond the Numbers: Numbers like the Sharpe ratio are helpful, but aren’t the whole story. You also need to think about what kind of assets are in the investment, what’s happening in the market, and your overall financial plan. These factors can all affect the risk-adjusted returns.
Practical Examples
– Example 1: Stock vs. Bond Fund: Let’s say you have to choose between a stock fund (12% return, Sharpe ratio of 0.6) and a bond fund (6% return, Sharpe ratio of 1.2). Even though the stock fund has a higher return, the bond fund provides a better risk-adjusted return. That means you’re getting more return for each unit of risk.
– Example 2: High-Risk Strategy: Imagine investing in small, risky companies (called small-cap stocks). These stocks might promise high returns, but if the Sharpe ratio is 0.4, it might not be worth the risk if you can’t handle it. On the other hand, a well-diversified portfolio with a Sharpe ratio of 1.0 might be more balanced, even if its raw returns are lower.
Conclusion
In investing, it’s not just about how much money you make, but how much risk you take to make it. Risk-adjusted returns help balance possible rewards with the risks involved. By understanding and using risk-adjusted returns, you can make smarter choices that fit your financial goals and comfort with risk.
Remember, smart investing isn’t about chasing the highest returns—it’s about finding the best returns for the risks you’re willing to take. And don’t forget to consider other factors too: Do your investments match your values? Will taxes reduce your returns? How will investment fees affect your gains? And how much stress can you handle along the way?