Risk-adjusted return

Definition

Risk-adjusted return is a financial metric that measures the return of an investment by considering the level of risk involved in generating that return. This approach helps investors compare different investments on a level playing field, as it accounts for both the potential profit and the volatility or uncertainty tied to those profits. Understanding risk-adjusted return is crucial for performance measurement, especially in international portfolios where varying risks across markets can significantly impact overall investment performance.

5 Must Know Facts For Your Next Test

1. Risk-adjusted return helps investors evaluate performance across different assets by normalizing returns based on their risk profiles.
2. It is essential for international portfolios since different countries can have varying levels of economic stability, regulatory environments, and currency risks.
3. Common methods to calculate risk-adjusted returns include the Sharpe Ratio and Treynor Ratio, both of which provide insights into return per unit of risk taken.
4. High risk-adjusted returns indicate that an investment offers good returns relative to the risks taken, making it attractive to investors.
5. Portfolio diversification can improve overall risk-adjusted returns by spreading out exposure to various risks associated with individual investments.

Review Questions

• How does risk-adjusted return enhance an investor's ability to make informed decisions when managing an international portfolio?
  • Risk-adjusted return provides a clearer picture of how well investments are performing relative to the risks associated with them. By assessing returns while factoring in volatility, investors can identify which assets or regions offer better rewards for their level of risk. This insight is particularly valuable in international portfolios, where risks can differ dramatically from one market to another, allowing for better allocation of resources and more strategic investment decisions.
• Compare and contrast the Sharpe Ratio and Treynor Ratio as measures of risk-adjusted return and discuss their applicability to international portfolios.
  • The Sharpe Ratio measures risk-adjusted return by evaluating excess returns over the risk-free rate relative to total portfolio volatility, making it useful for comparing portfolios with different levels of overall risk. In contrast, the Treynor Ratio assesses excess return per unit of systematic risk (beta), focusing on market-related risks. For international portfolios, both ratios are applicable but may yield different insights; the Sharpe Ratio is better for overall portfolio evaluation while the Treynor Ratio is beneficial for understanding performance in relation to market fluctuations.
• Evaluate the importance of achieving high risk-adjusted returns in an international portfolio and its implications for long-term investment strategies.
  • Achieving high risk-adjusted returns is crucial for long-term investment strategies, especially in international portfolios where geopolitical risks and market volatility can significantly affect returns. By focusing on investments that provide favorable returns relative to their risks, investors can enhance their overall portfolio performance while mitigating potential losses. This approach not only maximizes profitability but also contributes to more stable investment outcomes over time, ensuring that capital preservation and growth align with investors' financial goals.

Related terms

Sharpe Ratio:

A measure that indicates the average return earned in excess of the risk-free rate per unit of volatility or total risk.

Treynor Ratio:

A performance metric that evaluates how much excess return is generated for each unit of risk, using beta as the risk measure.

Alpha:

The excess return of an investment relative to the return of a benchmark index, indicating how much value an investment manager adds beyond market returns.