It is a concept which measures the value of risk involved in an investment’s return. It is of great importance because it enables the investors to make comparison between performance of a high risk, high risk investment return with less risky and lower investment returns. Risk adjusted return can apply to investment funds, portfolio and to individual securities.
Calculation of risk adjusted return
There are mainly five popular methods of calculating risk adjusted return such as Alpha, beta, r-squared, Sharpe ratio and standard deviation. Each of the method has its unique measures of risk, strengths and weaknesses and each has its own requirements for data like standard deviation and market performance, investment rate of return and risk free rate of return for a specific period. Investor can use any of calculation according to his choice. For comparison of two or more investments, investor must use same risk measuring method for each investment to get relative performance results.
Sharpe ratio is most widely used risk measuring tool. Through this method one can compute the expected return by potential impact of return volatility, the total earned amount of return on per unit of risk. An increase in Sharpe ratio of a fund means, its historic adjusted performance is better. An increase in number will bring an increase in return per unit of risk.
Sharpe ratio formula is
(Portfolio return – Risk free return) / Standard deviation of portfolio return
Risk adjusted return varies from person to person depending on several factors like risk tolerance, financial resources, willingness for holding a position for a long time for market recovery in the event investor made a mistake, investors opportunity cost and tax condition.
You can improve risk adjusted return byadjusting your stock position according to market volatility. An increase in volatility will decrease the equities position or vice versa. This strategy is really helpful to avoid big losses and to focus on significant gains. However one can never calculate exact risk adjusted return because of no specific rules. The basic phenomenon behind use of risk adjusted rate of return is that an investor can only rank them from lowest to highest in terms of attractiveness.
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