When investors make investment choices, they consider various factors. However, the most crucial among those is the risks and rewards they can get from those choices. Usually, investors expect the highest returns possible from their investments. However, each investment has a risk associated with it that can be detrimental to investors. Therefore, they may need to adjust their rewards for the risks they are willing to take.
What are Risk-Adjusted Measures of Performance?
Risk-adjusted measures of performance are metrics that can help investors adjust for the risks they take for their investments. These allow investors to consider both the risks and rewards they can get on their investments instead of focusing on returns only. Usually, the higher the risk is, the higher the returns are as well. By using risk-adjusted measures of performance, investors can compare various investments with varying risk levels.
There are several risk-adjusted measures of performance that investors can use. Among those, the most crucial is the risk-adjusted return. On top of that, investors can also use various ratios to compare investments that come with varying risk levels.
What is the Risk-Adjusted Return?
The risk-adjusted return represents the return that investors can get from an investment after accounting for the risks associated with it. As mentioned above, this metric allows investors to calculate the relative profits they can gain from their investments. By considering the risks associated with the investment, investors can get better insights into the rewards they can achieve.
The risk-adjusted return allows investors to compare various investments with varying risks. It works on a simple premise, allowing investors to choose investments with the highest returns for a given risk level. For example, if two investments offered the same returns, the risk-adjusted return will be higher for the ones with the lower risks.
What are some Risk-Adjusted Measures of Performance ratios?
Investors can get the risk-adjusted performance for an investment as ratios. It makes the comparison process more manageable, allowing investors to make better decisions. There are several ratios that can help investors gauge an investment's risk-adjusted performance measure. However, the most commonly used ones include the Sharpe and Treynor ratios.
Sharpe Ratio
The Sharpe Ratio allows investors to measure the returns they get from an investment that exceeds the risk-free rate per unit of standard deviation. Investors can calculate it by calculating an investment's market risk premium. After that, they must divide it by the investment's standard deviation to get the Sharpe ratio. Usually, investors prefer a high Sharpe ratio, which signifies the highest returns for the given standard deviation.
Treynor Ratio
Another ratio commonly used for risk-adjusted performance measures is the Treynor ratio. It uses the same principle as the Sharpe ratio. Instead of considering an investment's standard deviation, however, the Treynor ratio uses its beta. However, the ratio's principle remains the same. The higher the Treynor ratio is, the higher the risk-adjusted return for the investment will be.
Conclusion
Risk-adjusted measures of performance allow investors to calculate the returns they get from their investments after accounting for the risks. Therefore, these allow investors to compare investments based on how much risk they are willing to accept. There are several metrics that can help investors in calculating the risk-adjusted performance for investments.
Originally Published Here: Risk-Adjusted Measures of Performance
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