Definition of Risk-Adjusted Return
Risk-Adjusted Return is a financial metric that measures the profit earned on an investment relative to the amount of risk taken. Unlike raw returns, it adjusts performance to account for volatility, uncertainty, or downside risk. This ensures that two investments with the same return can be compared fairly by considering their risk exposure.
Meaning of Risk-Adjusted Return in Detail
Investors, businesses, and financial analysts recognize that higher returns often come with higher risks. A stock delivering 15% return may seem attractive, but if it comes with extreme volatility, it may not be better than a safer bond delivering 8% return.
That’s where risk-adjusted return becomes crucial. It answers:
👉 “How much return am I earning for every unit of risk I am taking?”
This helps portfolio managers, mutual funds, hedge funds, and even businesses in evaluating performance fairly rather than just chasing high returns.
Sub-Sections of Risk-Adjusted Return
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Raw Return vs. Risk-Adjusted Return
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Raw Return: Ignores risk, looks only at profit percentage.
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Risk-Adjusted Return: Considers both return and risk taken.
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Why It Matters: Investors prefer stable, consistent returns over high-risk unpredictable returns.
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Used In: Portfolio management, capital budgeting, mutual funds, hedge fund performance, and investment appraisals.
Formula of Risk-Adjusted Return
There are multiple ways to calculate depending on the model used. The most common:
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) / Standard Deviation of Portfolio
Other measures:
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Treynor Ratio = (Portfolio Return − Risk-Free Rate) / Beta
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Jensen’s Alpha = Portfolio Return − [Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)]
Example Calculation
Suppose:
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Portfolio Return = 12%
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Risk-Free Rate = 4%
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Standard Deviation (Volatility) = 10%
Sharpe Ratio = (12 − 4) / 10 = 0.8
Interpretation: The portfolio delivers 0.8 units of return per unit of risk. A higher ratio (>1) is generally considered good.
Key Features of Risk-Adjusted Return
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Adjusts returns by measuring volatility or systematic risk.
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Provides a fair comparison across different investments.
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Helps avoid misleading conclusions from raw returns.
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Can be expressed through multiple models (Sharpe, Treynor, Alpha).
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Widely used in mutual fund and hedge fund performance reporting.
Importance in Business and Finance
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For Investors: Helps choose between multiple assets with different risk profiles.
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For Fund Managers: Evaluates performance beyond absolute profit.
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For Corporates: Guides capital budgeting decisions by balancing risk with expected reward.
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For Regulators: Encourages transparent fund disclosures.
Advantages and Disadvantages
Advantages:
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Provides realistic evaluation of investment.
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Encourages risk management.
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Helps in constructing efficient portfolios.
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Facilitates comparison across asset classes.
Disadvantages:
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Different models give different results (Sharpe vs Treynor).
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Relies on assumptions (like normal distribution of returns).
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Risk-free rate estimation may be uncertain.
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Past volatility may not reflect future risks.
Usage of Risk-Adjusted Return
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Mutual fund comparison (investors check which fund gives better risk-adjusted performance).
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Hedge fund evaluation.
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Performance-linked bonuses for fund managers.
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Retirement planning (choosing stable funds).
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Corporate investment appraisal.
Case Studies
Case 1: Mutual Funds in India
Two equity funds delivered 15% and 13% returns. But after applying the Sharpe ratio, the second fund showed better risk-adjusted return due to lower volatility. Many investors shifted towards it despite lower absolute return.
Case 2: 2008 Global Financial Crisis
Portfolios with high absolute returns before 2008 collapsed because their risk-adjusted return was weak. Funds with better Sharpe ratios survived with lesser losses.
Practical Example
Investor A invests in Stock X (return 20%, volatility 15%).
Investor B invests in Stock Y (return 14%, volatility 5%).
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Stock X Sharpe Ratio = (20−4)/15 = 1.06
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Stock Y Sharpe Ratio = (14−4)/5 = 2.0
👉 Even though Stock X has a higher return, Stock Y is better risk-adjusted.
Common Mistakes or Misunderstandings
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Believing high returns = better investment.
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Ignoring risk-free rate in calculations.
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Confusing different models (Sharpe vs Treynor).
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Using past returns without considering future market risks.
Real-Life Applications
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Mutual Fund Ratings: Agencies like Morningstar use risk-adjusted return to rate funds.
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Portfolio Construction: Used in asset allocation strategies.
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Pension Funds: Preference for stable high risk-adjusted returns.
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Corporate Finance: Used in evaluating capital projects.
FAQs
Q1. What is a good risk-adjusted return?
A Sharpe ratio above 1 is generally considered good, above 2 excellent.
Q2. Is it used only in stock markets?
No, it applies to bonds, mutual funds, real estate, and business projects.
Q3. Can risk-adjusted return be negative?
Yes, if the return is below the risk-free rate.
Q4. Which ratio is most commonly used?
Sharpe ratio is the most widely used globally.
Expert Tip from Learn with Manika
"Always look at the risk-adjusted return, not just raw returns. High profit with high risk can be misleading. A balanced, steady portfolio often wins in the long run."
Related Terms
- Sharpe Ratio
- Treynor Ratio
- Jensen’s Alpha
- Capital Asset Pricing Model (CAPM)
- Risk-Free Rate
- Portfolio Volatility