How to Calculate Risk Using Risk-Adjusted Return Ratios
Understanding where your portfolio is growing and how much risk you’re assuming is crucial to making healthy financial investments. Risk is often a buzzword that investors talk about in terms of their latest acquired asset, but few people know how to look at risk-adjustment returns and the ratios that measure them. How can you pick up new tricks as an investor and reach your long-term financial independence goals?
If you want to maximize your return on investment, that means diving into risk-adjusted returns. Here’s what you need to know to measure this figure on your own before heading to your financial advisor.
What is a Risk-Adjusted Return?
Any type of investing involves a degree of risk, and focusing on the positives and potential behind that risk is a crucial part of developing a wealth mindset. But optimistic outlook or not, you shouldn’t jump into a risky opportunity without doing your research first.
A risk-adjusted return is a measure investors use to determine how much they can profit from the purchase of an individual stock, investment fund, or on their portfolio overall. It considers the potential profit along with the risk. In other words, a risk-adjusted return ratio helps investors take a careful look at how much they can gain and how much they can stand to lose.
How does calculating a risk-adjusted return work?
Let’s consider the case of someone who made two investments, both with an equal rate of return. While both had the same potential profit, they did not have the same risk. One was a risky stock, while the other was held in treasury bonds. In this case, the risk-adjusted return would favor the treasury bonds because it assumed the lower risk.
The risk-adjusted return is a big deal – it lets investors know how valuable the returns will be and whether there are potential downsides. For example, you might realize the potential reward isn’t worth the risk that you would have to take.
It’s a law of diminishing returns: at a certain point, too much risk becomes less attractive, even if it has a potentially huge payoff. A risk-adjusted return helps you to see when this might be the case before you spend your hard-earned cash diversifying your investment portfolio – or starting one for the first time.
Key Terms to Understand Risk-Adjusted Returns
Before we dive into how to calculate your risk using risk-adjusted return ratios, we’ll need to establish a few key definitions so you can follow along with the formulas.
Standard Deviation
This is a metric to measure an investment’s volatility. A large standard deviation means a wider range of returns, while a small standard deviation tends to be more consistent.
Alpha
This performance metric is used to compare an investment’s returns to a benchmark like the S&P 500. A positive beta indicates that the investment tends to beat the benchmark, while a negative beta doesn’t. In other words, you want a positive alpha.
Examples:
Alpha of 1 = investment has historically outperformed its benchmark index by 1%
Alpha of -1 = investment has generally underperformed its benchmark by 1%.
Beta
While alpha tries to predict performance, neta estimates an investment’s risk and volatility compared to a market benchmark – again, like the S&P 500. Betas above 1 are typically more volatile than the market, while those below 1 are less volatile.
Negative betas are rare, but it means the investment is inversely correlated to the market.
Examples:
Beta of 1 = Investment matches the benchmark’s price activity
Beta of 1.6 = Investment is perceived to be 60% more volatile than the market
Beta of 0.5 = Investment is half as volatile as the market
Risk-Free Rate
This rate represents the expected return you might get in a theoretical zero-risk investment over a period of time. Risk-free rates are generally theoretical and don’t truly exist, since every investment will hold some degree of risk – even if it’s very small.
Securities offered by the U.S. government are generally considered the closest you can get to a risk-free investment, since the federal government has never defaulted on its debt. Since U.S. Treasury bills (often called “T-bills”) offer the shortest maturity dates, U.S.-based investors often use the interest rate on a three-month T-bill as the risk-free rate to calculate ratios.
Common Types of Risk-Adjusted Return Ratios
With all that said, calculating risk-adjusted return ratios is a bit complex. There are a handful of ways to calculate this figure, with the most common including the Sharpe, Treynor, and Sortino ratios.
Here’s a quick look at how these ratios are calculated and what they mean for your portfolio.
Sharpe Ratio
First and foremost, most investors will come up against the Sharpe ratio at some point. This figure looks at the profits that were generated by your investment without calculating risk. The higher the ratio, the more worthwhile investors will find the asset.
In order to use this, you have to know how it exceeds the risk-free rate per unit. This is usually a measure used on a low- to no-risk investment (such as bonds) over the same period of time that you might hold the investment.
Calculating the Sharpe ratio doesn’t have to be complicated though. The formula looks something like this:
(Return of the Investment – Risk-Free Rate) / Investment’s Standard Deviation
Keep in mind that this doesn’t necessarily tell you which investment had the higher rate of return. Instead, it focuses on investments that have more gain per total risk.
Treynor Ratio
Once you have the Sharpe ratio down, move onto other simple calculations like the Treynor ratio. This is calculated almost identically to the Sharpe ratio with one quick substitution: instead of dividing by the investment’s standard deviation, you will divide by the beta (the risk assumed in an investment when compared to the whole market; it usually follows the S&P 500).
(Return of the Investment – Risk-Free Rate) / Investment’s Beta
You might get the opposite outcome of your Sharpe ratio when you run the Treynor ratio.
This outcome is not necessarily good or bad. It just indicates that you have more return for the risk with this investment. A higher Treynor ratio indicates that your portfolio is in good shape and has the potential to be a worthwhile long-term investment.
Sortino Ratio
Risk-averse investors may prefer a different measure of risk in their portfolios, namely the Sortino ratio. The calculation is similar to the Sharpe ratio, just like the Treynor ratio. In fact, when it comes to risk-adjusted returns, you might want to run all three calculations to get a clearer picture of your investment.
Instead of dividing by the standard deviation as you did with the Sharpe ratio, you’ll divide by the downward distribution of returns below the average. As with the Sharpe and Treynor ratios, look for the highest rate.
(Return of the Investment – Risk-Free Rate) / Standard Deviation of Negative Earnings
Even though an investment may have a lower standard deviation, other investments may actually score higher on the Sortino ratio test. This helps you weed out investments that underperform on average.
Take the Next Step Toward Financial Freedom
Unfamiliarity with topics like risk-adjusted return ratios and investment best practices shouldn’t hold you back from achieving financial independence. If you’re ready to grow your wealth and live the life you’ve always dreamed about, it’s time to add Black Mammoth to your family.
We’re passionate about helping you achieve financial success through education and expert guidance. Whether you want someone to take over your accounts and optimize your investment portfolios or simply provide a second opinion, we’re here to support you. Say goodbye to financial uncertainty – reach out today and schedule a consultation.