risk-adjusted return on capital

Fin

return on capital calculated in a way that takes into account the risks associated with income.

EXAMPLE

Being able to compare a high-risk, potentially high-return investment with a low-risk, lower-return investment helps answer a key question that confronts every investor: is it worth the risk?

     There are several ways to calculate riskadjusted return. Each has its strengths and shortcomings. All require particular data, such as an investment’s rate of return, the risk-free return rate for a given period, and a market’s performance and its standard deviation.

     The choice of calculation depends on an investor’s focus: whether it is on upside gains or downside losses.

     Perhaps the most widely used is 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 better its historical risk-adjusted performance, and the higher the number the greater the return per unit of risk. The formula is:

(Portfolio return – Risk-free return)/Std deviation of portfolio return = Sharpe ratio

Take, for example, two investments, one returning 54%, the other 26%. At first glance, the higher figure clearly looks like 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.

     The Treynor ratio also measures the excess of return per unit of risk. Its formula is:

(Portfolio return – Risk-free return)/ Portfolio’s beta = Treynor ratio

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 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 a investment’s risk was worth its reward. The formula is:

(Portfolio return – Risk-free return) – Portfolio beta × (Benchmark return – Riskfree return) = Jensen’s measure