Risk Adjusted Return

Definition of Risk Adjusted Return

Risk adjusted return are free from the risk associated with earned returns. The investor can consider risk-free or risk-adjusted returns in this type of investment. The risk from this type of investment can be compared with the risk-free investment. The risk can be adjusted to a relatively lower level in this case. Several approved methods can be used to calculate the risk levels for this type of investment, and then, as per convince, the risk can be adjusted.

Explanation

The risk associated with any returns is calculated with the help of prescribed formulas. The rate of returns is also calculated with the use of formulas. The investors must determine how much returns are required from their investment in a particular stock or shares of a company. Then, the investors can compare the expected and required returns, and the risk associated with this type of investment can also be compared. Investors should simultaneously focus on the risk and return to earn better profits from the investments. It is always advisable that the investors keep track of the correct evaluation of the risk from the investment. Thus a comparison can be drawn between the expected returns and the required rate of return. Investors can choose from calculating methods and rely upon the risk calculated to make a fair decision for the risk-adjusted return. Calculating the risk-adjusted returns of any stock is done by evaluating the investor’s portfolio, also known as the Sharpe ratio.

How to Calculate Risk-Adjusted Return?

• First, the stocks identified in which the investment is to be made.
• Then the investors are required to compute the returns from the investment.
• After evaluating the returns, the risk is calculated using prescribed formulas to compare two or more stocks.
• The risk-free rate is then found from the stocks, and Sharpe’s ratio method is selected to determine the risk-adjusted returns.
• After that, the Sharpe ratio is calculated for the stock; the higher the Sharpe ratio of the stock, the better the investment in that stock if the risk-adjusted return is the metric.

Examples of Risk-Adjusted Return

An investor is looking for a better investment for his portfolio, and thus he has invested in two stocks, for example, to check which stock is better by comparing the risk-adjusted return of the two. The investor will be using the Sharpe Ratio to make that comparison.

The stocks are X and Y. The stock returns are 25% from X and 30% from Y. The risk-free rate is 8% in the market. The risk associated with the stocks is 10% for X and 15% for Y. The investor wants us to give him the correct risk-adjusted return calculation for both stocks so that he will make the correct decision for the same.

Solution:

Particulars	Return (%)	Risk-Free Return	Risk (%)	Sharpe Ratio (%)
X	25	8	10	1.70
Y	30	8	15	1.47

The Sharpe Ratio is calculated with the help of this formula:-

Sharpe Ratio = (Return – Risk Free Return) / Risk of The Stocks

In this example, stock X has more Sharpe Ratio than Stock Y. Thus the investor should consider investing in stock X if the consideration is of Risk-adjusted return of the individual stock.

Importance

• The investor should always calculate the risk-adjusted return before analyzing the investment to earn.
• The investor can make out their mind about the investment in the stock or shares, which is beneficial in the context of the risk associated with the returns.
• By calculating the risk-adjusted returns, investors can easily select the investment options that will help them calculate the risk and the returns.
• The investor will get an idea of the investment to be made, and thus he will be able to make the correct decision regarding the investment.
• It can be calculated with the help of the prescribed formula, and thus the investors will always know the risk rate of their investment.
• The investment decision cannot be based merely on returns earned from the portfolio or stock. The decision will also depend on the risk-adjusted returns, and for any stock, the better risk-adjusted return ratio will be the outcome of the investment from that stock.

Advantages

Some of the advantages are given below:

• The investor can analyze the performance of the investment he will make.
• The investor can make his mind clear about the risk tolerance associated with his stock returns.
• The portfolio evaluation can be done very quickly because the risk-adjusted return will make the investor understand the better option which can be chosen if the risk-adjusted return is the metric.
• The portfolio can be adjusted if the investor understands the risk-adjusted returns investment policy.
• The stock’s performance can also be easily assessed with its help.
• It is a tool that investors use to make a good decision on investment to be made.
• The risk tolerance level can also be tested and analyzed for the investors, who will help them make the appropriate decisions.

Conclusion

It is a tool helping investors decide by calculating the risk-adjusted returns for each stock. Investors can understand the risk tolerance level at every stage to make a good decision regarding their investment and plan or reset their portfolio. The investor can evaluate the portfolio using the Sharpe Ratio, which tells them the risk-adjusted return of that stock.

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