RISK ADJUSTED RETURN: Ratios, Formula and Calculations

risk adjusted return

In real estate, the return on investment is more than just a statistic. While a higher return may appear to be a good thing at first look, there is more to it than meets the eye. Because it incorporates the relative risk of the investment in relation to its return, a risk-adjusted return is typically regarded as a more accurate approach to evaluate and analyse a real estate investment. Learn what risk-adjusted return is, the ratios, the calculations, and how it’s utilised in investing if you want to invest actively or passively in real estate.

What is a Risk-Adjusted Return?

A risk-adjusted return is a calculation of an investment’s profit or potential profit that takes into account the degree of risk that must be incurred in order to achieve it. The risk is calculated in relation to a virtually risk-free investment, often US Treasuries.

The risk-adjusted return calculation is expressed as numbers or ratios depending on the approach utilised. Individual stocks, investment funds, and entire portfolios are all subject to risk-adjusted returns.

What are the Risk-Adjusted Return Ratios (RARRs)?

A variety of risk-adjusted return ratios are available to assist investors in evaluating existing or potential investments. The risk-adjusted ratios can be more useful than simple investment return indicators that do not account for the level of investment risk.

There are numerous methods for calculating risk-adjusted returns. The following are some of the most widely utilised methodologies:

#1. The Sharpe ratio

This is one of the most common methods for calculating risk-adjusted returns. The calculation was created and named after William Sharpe, an American economist and Nobel Laureate.

The Sharpe ratio, in essence, separates the average profits made by an asset irrespective of risk. A greater Sharpe ratio indicates a more worthy investment and is beneficial when comparing opportunities or allocating resources.

The Sharpe ratio measures an investment’s excess returns over the risk-free rate per unit of volatility using standard deviation, a statistical measure of variation. A mutual fund that returns 11% on average over four years with a standard deviation of 5% would be anticipated to return between 6% and 16% in any given year over that time period.

The calculation is as follows:

Subtract the risk-free rate from the return on an asset. U.S. Treasury bills are commonly used as a benchmark since they are a known asset with near-zero risk.

Divide that figure by the asset’s standard deviation of return. The standard deviation illustrates the return data distribution. The presence of highly concentrated data suggests lower volatility, but a wider range of data may imply increased volatility.

A Sharpe ratio of 0 indicates that there are no returns over the risk-free rate. As an example, consider the following:

  • The mutual fund A yielded a 9 percent return. We derive a Sharpe ratio of 1.3 by subtracting the risk-free rate of 2.5 percent and dividing it by the standard deviation of 5.
  • Mutual fund B returned 13% but had a standard deviation of 11.75, resulting in a Sharpe ratio of 0.9.

Any ratio greater than one is regarded as good, with 2 to 3 being excellent and anything greater than that a superb bet. In this manner, investors may see the excess returns they can expect in exchange for each unit of risk. Mutual fund A may be regarded as the better investment although returning less on average.

#2. Sortino ratio

It is just as crucial to avoid losing money as it is to make money. Many asset managers may be more concerned with potential downside when making investment decisions, which is where the Sortino ratio comes into play.

Both are set up similarly, and a larger ratio is deemed desirable in both circumstances. The Sortino ratio, on the other hand, does not employ the complete standard deviation of an asset, as the Sharpe ratio does, but only the downward distribution of returns below average.

Continuing with the previous example,

  • Mutual fund A has a Sortino ratio of 0.44 and a downside standard deviation of 15.
  • Mutual fund B has a Sortino ratio of 1.75 and a downside standard deviation of 6.

Despite having a lower standard deviation than mutual fund B, mutual fund A is more likely to underperform expected returns on average. As a result, its Sortino ratio is smaller, making mutual fund B the more appealing alternative in some evaluations.

#3. Jensen’s alpha.

Many investors are familiar with the phrase alpha. It is a performance metric for active returns that outperform the market. Jensen’s alpha incorporates a risk-adjusted component that compares asset performance to a benchmark index in order to evaluate active, or abnormal, returns. This is accomplished by applying the beta coefficient of the asset, which is a measure of volatility.

The formula is as follows: Portfolio Return [Risk-Free Rate + Portfolio Beta x (Market Return Risk-Free Rate)]

Continuing with our example (which assumes a risk-free rate of 2.5 percent), let’s add a benchmark index variable of 10.5 percent:

  • Jensen’s alpha is 1.3 because mutual fund A has a beta coefficient of 0.65.
  • Jensen’s alpha equals 0.9 because mutual fund B has a beta coefficient of 1.2.

Positive alpha suggests that an investment or asset manager has outperformed the market. However, in this scenario, mutual fund B does not outperform mutual fund A in terms of the amount of risk it is taking on.

When you talk about alpha, you have to talk about the beta as well. The two are analogous to the yin and yang of investing measures. Whereas alpha evaluates performance in relation to a benchmark, beta measures volatility in relation to the benchmark. For example, beta may imply that a mutual fund is more vulnerable to risk than its underlying assets, such as an index. Beta can be beneficial in developing risk-adjusted investment strategies that capitalise on the potential for returns.

#4. R-squared

R-squared expresses the link between a fund and its benchmark index as a percentage ranging from 1 to 100. While not a performance statistic in and of itself, R-squared might be useful in analysing whether you’re getting the most bang for your buck in terms of risk-adjusted returns.

R-square calculates the correlation between the fund’s and its benchmark’s movements. With an R-squared value of 100, every trend in the fund’s pricing can be explained by the identical movements in the benchmark index. That’s not so bad if it’s a passive fund, but for an actively managed fund. It means paying management fees with nothing to show for it other than index-driven movement.

Investors may want a lower R-squared value to justify the risk incurred by active strategies. R-squared general ranges, according to Morningstar, are:

  • Correlation is high: 70-100 percent.
  • 40-70 percent is the average correlation.
  • The correlation is low: 1-40%.

#5. Treynor ratio

This calculation is comparable to the Sharpe ratio, except it includes the beta coefficient, similar to Jensen’s alpha. A greater number, as with the Sharpe and Sortino ratios, implies a more appealing investment prospect. It, like R-squared, can be used to calculate the payoff for a unit of risk assumed by a portfolio or fund.

  • The Treynor ratio for Mutual Fund A would be 1.0.
  • The Treynor ratio for Mutual Fund B would be 0.88.

Why should you consider risk when investing?

It is critical to account for risk while investing because:

  1. It is a fund management metric: Measuring risk is a rational and objective way to assess the abilities of your fund manager, advisor, or financial expert. A fund manager’s ideal goal is to accept the least amount of risk while delivering outstanding returns.
  2. Aids in determining investment quality: You can distinguish between riskier and less risky assets and know exactly what you are investing in without any uncertainty.

Risk-adjusted Return Application in Real Estate Investing

This statistic is most typically used when selling an investment opportunity to investors or when professionals, such as a fund manager or portfolio manager, evaluate the performance of their fund. It enables them to examine the investment portfolio’s performance measure to determine whether assets are doing the best or causing the most vulnerabilities for the portfolio.

On a more basic level, you may come across this word when reading a quarterly or yearly earnings report from a real estate investment trust (REIT) or when examining a crowdfunding investment offering memorandum. Understanding what the rate genuinely means will assist you in making informed judgments about purchasing the stock, REIT, or investment, as well as comparing the return to other assets that may not be risk-adjusted.

While the Sharpe ratio calculation can be useful, it requires performance data in order to be performed correctly. Most ventures, particularly new purchases, lack that data to supply at the outset. As a result, investors are left guessing about what risk measures exist.

How to Reduce the Risk of an Investment

If you don’t have access to real-world data, the next best thing is to examine the investment’s entire risk profile. Determine its flaws and possible vulnerabilities. Supply and demand, the market in which the property is located, the quality and experience of the sponsor or portfolio manager, the type of property, the amount of debt, and the interest rate on the debt will all play a role in the risk that the portfolio or investment bears. Rarely is a single factor a dead giveaway; rather, it is a mixture of them that raises total risk. Take these risks into account and use them as a variable to reduce the average return by a point or two – or more if the investment at hand appears to be particularly risky. This will give you a more accurate picture of the adjusted return.

Conclusion

Risk-adjusted return is used to calculate how much return an investment portfolio generates in proportion to the risk involved, which is expressed as a number, and it can be applied to investment funds, individual securities, and investment portfolios, among other things.

Risk-adjusted return varies from person to person and is determined by a variety of characteristics such as risk tolerance, availability of cash, and willingness to hold a position for an extended period of time in anticipation of a market rebound. In the event that the investor makes a mistake in judgement, the opportunity cost of the investor as well as his tax situation will be determined.

An investor can boost his risk-adjusted return in a variety of ways. One of the most prevalent methods is to modify his stock position in response to market volatility. An increase in volatility frequently results in a drop in the equity position, and vice versa. Fund managers are increasingly using this method to avoid significant losses and focus on maximising gains.

Risk-ajusted Return FAQs

What measures risk adjusted returns?

There are five possible measures: Alpha, Beta, R-squared, Standard Deviation, and Sharpe Ratio. All of these indicators provide investors with particular information regarding risk-adjusted returns.

Is CAPM risk-adjusted return?

The CAPM return is expected to be ‘risk-adjusted,’ which means it takes into consideration the asset’s relative riskiness. This is based on the idea that higher-risk assets should have higher expected returns than lower-risk ones.

What Sharpe ratio is good?

Investors often regard any Sharpe ratio more than 1.0 to be acceptable to good. A ratio greater than 2.0 is considered extremely good. A ratio of 3.0 or greater is regarded as outstanding. So a ratio less than 1.0 is deemed suboptimal.

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