Risk adjusted return tells us about the return generated from an investment with a given level of risk .It gives an insight to the investor to differentiate between the high risk and low risk investments ,so that the investor can make an appropriate choice of his investment. The risk adjusted return is very important for the investors to figure out if they are realizing maximum returns with a certain minimal level of given risk. Risk adjusted returns are calculated in case of individual stock, security, portfolio or when investing in a fund consisting of several classes of assets.
Some of the risk adjusted return calculation measures which are used to calculate returns on a given level of risk are as follows :
- Sharpe ratio : Sharpe ratio = (Mean portfolio return – Risk free rate)/Standard deviation of portfolio return
- Treynor’s ratio : (Average Return of a Portfolio – Risk free rate)/Beta
- The higher the sharpe and treynor’s ratios, the better is the risk adjusted return per unit of risk.
- Alpha : It tells you whether the return on portfolio has outperformed the market with a certain given level of risk. If the alpha is equal to positive 1 ,it means that the stock has outperformed the market index by 1 percent ,a negative 1 alpha would mean underperforming by 1 percent.
- Beta: It is the measure of volatility which tells how much risk is involved with an investment compared to the market risk . A beta of 1.3 would mean stock is 30 % more volatile than the market risk (taken to be one )
- R squared :It tells the correlation between a portfolio’s price movements with a benchmark (some market benchmark).Investors are interested in this because it explains portfolio’s performance based on the market movements .Measured between 1 to 100. Value between 70 % to 100 % suggests a high correlation .values lower than 40 % suggests lower correlation.
- Standard deviation : It explains variation of returns of portfolio from it’s mean returns over a period of time .Suppose the return generated on a portfolio over a period of 5 years is 12 % with a standard deviation of 5 ,the investor then can reasonably expect portfolio to generate returns between 7 % to 17 % (plus minus 5 of 12%)
These different means of calculating risk adjusted returns are used as per individual discretion , and is used simultaneously to take investment decisions on all the measures together.