Risk-Adjusted Return

Two investments with the same return are not equally attractive if one achieved it with much more risk. Risk-adjusted return looks at return per unit of risk.

For example, Fund A returned 10% with large swings in value, while Fund B returned 8% with much smaller swings. On a raw basis, Fund A looks better. But after adjusting for risk, Fund B may have delivered more return for each unit of risk taken.

Several measures are used. The Sharpe ratio compares excess return over a risk-free rate with total volatility. The Sortino ratio focuses only on downside volatility. The Treynor ratio uses beta, which measures exposure to market movements. Alpha measures return above what would be expected for the risk taken.

Risk-adjusted measures help investors judge whether a manager's performance came from skill or simply from taking more risk. They are widely used to compare funds and portfolio managers.

Each measure has limitations. Most rely on historical data, and volatility does not capture every type of risk, such as the chance of rare but severe losses.