Risk Adjusted Return

Risk adjusted return is a concept that measures how much risk is involved in the return. This measurement is generally expressed as a number rating. Risk adjusted returns applies to mutual funds, investment funds, individual securities and other similar methods of investing. The amount of risk is determined by comparing the difference between the investments return against a benchmark. The benchmarks performance compared to the investments return allows for investors to see if there is additional return or loss on an investment. The purpose of risk adjusted return is to deter investors from purchasing high-return assets that come with unnecessarily high risk.

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There are 5 different methods of evaluation that go into calculating risk adjusted return. Each method has a different focus for how it measures risk. Here are the 5 methods of determining risk adjusted return:

Alpha: The measure of an investments performance compared to a basic benchmark, such as the S&P 500. Alpha is an indication of what a portfolio manager is bringing to your investments. Depending on the current market, alpha can show if your financial advisor is outperforming, underperforming, or keeping your investments in balance. Alpha is able to measure more-than-average and less-than-average gains and losses in accordance to the given measure. An alpha of 3.0 means an investment has outperformed the benchmark index by 3 percent. Similarly, a negative 3.0 represents underperformance of 3 percent.

Beta: The Beta calculation works in accordance with the alpha calculation. The beta is a measure of the volatility of investments compared to the rise or fall of the stock market. The beta can work with the alpha to deliver a beta-adjusted return.

This means that a portfolio manager who delivers higher returns with less risk has a higher alpha due to the reduced risk involved with the investment. The beta method of evaluation is a supplement to the alpha method of calculation.

R-squared: The r-squared method of evaluation examines the correlation of a portfolios price trends against a benchmark. The r-squared is not a performance measure, unlike the alpha and beta. The r-squared method of evaluation tracks movement that is not relative to return. This means that it measures how your portfolio is going in the grand scheme of things among broader markets. The r-squared statistic is represented in a range of 1 to 100 and tracks how your portfolio moves (up or down) in accordance to the benchmark. If your statistic is 40 percent or lower, a low correlation to the benchmark is suggested.

Sharpe Ratio: this statistic measures return versus risk. The Sharpe ratio is one of the more complicated ratios among the group (we understand this might seem as logical as a foreign language you don't know) but it is essential to investors when measuring risk adjusted return. An investor determines how a fund performs. Then they subtract that return by the amount you would have earned with a risk-free investment during the same investment period. Once you have that number, you divide it by the portfolios standard deviation. The higher the Sharpe ratio the more youve made off the risks youve taken. The Sharpe ratio acts as a measure for risk checkpoints and can determine if your financial advisor is performing well with your stocks.

Standard Deviation: weve all heard about standard deviation from a previous math class, but now it applies to finance too, just in a different way. The standard deviation is a measure of an investments risk and how it varies to the investments average return. The standard deviation is used to track investments from year to year, for as long as up to 36 years. How your investment changes from year to year determines the standard deviation.

Risk adjusted return may seem more complicated than its worth, but ultimately its simply taking a second look at your potential investments. Take a moment to look beyond the headline to determine if the risk associated with that investment is right for your portfolio, itll be well worth the work.

Whether you find investing stressful, want to make sure you have assistance with your portfolios, or simply dont have the time; MyRetirementPlan is here to help you secure your future. With a proven data driven process, we carefully calculate your levels of risk, the risk adjusted return of your potential investments and create a portfolio that meets all your needs. Contact us today for a free consultation.