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Wealth management Risk return adjusted cost
1.
2. A concept.
Refines an investment's return.
Measuring how much risk is involved in producing that
return.
Is generally expressed as a number or rating.
Risk-adjusted returns are applied to individual
securities and investment funds and portfolios.
3. Able to compare a high-risk, potentially high-return investment with a low-risk,
lower-return investment
Helps to answer a key question that confronts every investor: Is it worth the risk?
By itself, the historical average return of an investment, asset, or portfolio can be
quite misleading and a faulty indicator of future performance. Risk-adjusted return
is a much better barometer.
The calculation also helps to reveal whether the returns of the portfolio reflect
smart investment decisions,
The taking on of excess risk that may or may not have been worth what was gained.
This is particularly helpful in appraising the performance of money managers.
4. There are five principal risk measures:
Alpha
Beta
R-squared
Standard deviation
The Sharpe ratio.
Each risk measure is unique in how it measures risk. When
comparing two or more potential investments, an investor should
always compare the same risk measures to each different
investment in order to get a relative performance perspective.
5. The Sharpe ratio. This measures the potential impact of return volatility on
expected return and the amount of return earned per unit of risk. The higher a
fund’s Sharpe ratio, the bette its historical risk-adjusted performance, and the
higher the number the greater the return per unit of risk. The Formula is:
Sharpe ratio = (Portfolio return – Risk-free return) ÷ Standard deviation of
portfolio return
Take, for example, two investments, one returning 54%, the other 26%. At first
glance, the higher figure clearly looks the better choice, but because of its high
volatility it has a Sharpe ratio of 0.279, while the investment with a lower
return has a ratio of 0.910. On a risk-adjusted basis the latter would be the
wiser choice.
6. The Treynor ratio also measures the excess of return per unit of risk. Its
formula is:
Treynor ratio = (Portfolio return – Risk-free return) ÷ Portfolio’s beta
In this formula (and others that follow), beta is a separately calculated figure
that describes the tendency of an investment to respond to marketplace swings.
The higher the beta, the greater the volatility, and vice versa.
A third formula, Jensen’s measure, is often used to rate a money manager’s
performance against a market index, and whether or not an investment’s risk
was worth its reward. The formula is:
Jensen’s measure = Portfolio return – Risk-free return – Portfolio beta ×
(Benchmark return – Risk-free return)
7. A fourth formula, the Sortino ratio, also exists. Its focus is more on downside risk
than potential opportunity, and its calculation is more complex.
There are no benchmarks for these values. In order to be useful the numbers should be
compared with the ratios of other investments.
No single measure is perfect, so experts recommend using them broadly. For instance, if
a particular investment class is on a roll and does not experience a great deal of
volatility, a good return per unit of risk does not necessarily reflect management genius.
When the overall momentum of technology stocks drove returns straight up in 1999,
Sharpe ratios climbed with them, and did not reflect any of the sector’s volatility that
was to erupt in late 2000.
Most of these measures can be used to rank the risk-adjusted performance of individual
stocks, various portfolios over the same time, and mutual funds with similar objectives.
8. A rate of return used in financial analysis
Riskier projects and investments are evaluated based on the capital at risk.
RORAC makes it easier to compare and contrast projects with different risk
profiles.
Allocated risk capital = the firm's capital, adjusted for a maximum potential
loss based on the probability of future returns or volatility of earnings.
RORAC is used more as companies place greater emphasis on firm-wide risk
management.
9. For example, different corporate divisions with unique
managers can use RORAC to quantify and maintain
acceptable risk-exposure levels.
This calculation is similar to risk-adjusted return on capital
(RAROC); however, with RORAC, the capital is adjusted
for risk, not the rate of return. RORAC is used when the
risk varies depending on the capital asset being analyzed.
