Including risk-adjusted returns into your finances can be difficult without knowing how to find the best investments for your financial plans. Often, investors looking to improve their portfolios can become excited with the prospect of earning more profits that they can lose sight of which investments are truly meeting their goals. To better decide the best investments for your savings, then, let’s review what risk-adjusted returns are, as well as which ways to calculate those return investments.
What Is a Risk-Adjusted Return?
A risk-adjusted return is the calculation of profits or potential profits earned over time from an investment that accounts for the degree of risk needed to achieve it compared to one without risks. Financially speaking, such risks measure the chances of an investment performing differently from its expected goal, resulting in a ratio based on past data and deviations to determine return.
Applied to investment stocks, funds and portfolios, and of course real estate, higher risk-adjusted return ratings typically produce better returns for investors, with higher-risk investments generally yielding more success than low-risk assets. However, no investment is truly risk-free, and must therefore be considered with caution by investors before being accounted into personal finances.
Calculations for Risk-Adjusted Returns
Since risk-adjusted returns measure your investment’s profits against how much risk the investment presents within a certain time, calculating risk-adjusted returns comes down to figuring out which of the two investments holds the lowest risk and—in turn—yield better profits. Here, we review some of the most common ways to calculate risk-adjusted returns:
Sharpe ratio
Developed and named after the American Nobel Laureate, William Sharpe, the Sharpe ratio calculation measures risk-adjusted returns by separating a risk-free asset’s average profits.
To calculate a risk-adjusted return via Sharpe ratio, simply:
Subtract the risk-free rate—such as U.S. Treasury bills that are nearly risk-free assets—from an asset’s return.
Then, divide results by the standard deviation of the asset’s return. Highly concentrated distribution return data suggests more stability, while wide-spread data proposes instability.
Any risk-adjusted return results of 0 indicate no returns outside the risk-free rate. As a result, not only can investors find the best investment opportunity by highest ratio, but also measure the excess returns of investments outside the risk-free rate per volatility unit.
Sortino ratio
When picking investments, investors or financial managers worried about potential losses with risk-adjusted returns can utilize the Sortino ratio calculation. Although similar to the Sharpe ratio where higher ratios show better investments, the Sortino method focuses only on the downward distribution of risk-adjusted returns below average.
To calculate risk-adjusted returns via Sortino ratio:
Subtract your investment portfolio’s total profits from the return’s risk-free rate.
Then, divide by the standard deviation of negative earnings.
Through the Sortino method, investors can find the potential downside risks involved in certain investments, wherein comparing two investments one can discover which is more likely to fail over the other. Therefore, investors can find more profitable risk-adjusted returns by weeding out poor results with the Sortino ratio.
Jensen’s Alpha
With the Jensen’s Alpha calculation, investors can measure the performance of active returns, ultimately helping to determine which investments will succeed in the market. Jensen’s Alpha includes in its calculation a risk-adjusted element that measures assets against a set benchmark to highlight normal or abnormal risk-adjusted returns. This is done by using the asset’s beta coefficient, which is a measure of volatility.
To calculate risk-adjusted returns with Jensen’s Alpha, the formula includes the asset’s measured volatility, or beta coefficient, as follows:
Portfolio Return − [Risk Free Rate + Portfolio Beta x (Market Return − Risk Free Rate)]
As alpha measures return performance relative to a set benchmark, beta measures which return investment is exposed to higher risk, thereby making it perfect for investors looking to cut return risks in their investment plans or portfolios.
R-squared
R-squared ratios calculate the relationship of movement between a risk-adjusted return and its benchmark through a percentage from 1-100. R-squared calculations greatly assist investors hoping to receive the most in risk-adjusted returns on investments. Essentially, the best results to look for in investments lie within the 1 to 100 range, as 100% may increase payments on investments rather than greater returns.
In short, investors need a lower R-squared value to justify taking risks in active investment strategies.
Calculate risk-adjusted returns using the following R-squared formula:
R-Squared= 1- (Sum of First Errors/Sum of Second Errors)
Here are the following ranges best suited to risk-adjusted returns through R-squared:
High correlation: 70-100%
Average correlation: 40-70%
Low correlation: 1-40%
Treynor ratio
Structured similar to the Sharpe method, the Treynor ratio calculates risk-adjusted returns by incorporating the beta coefficient via Jensen’s alpha. Like R-squared, the Treynor method is used to measure reward for units of risk taken on by an investment portfolio or fund.
To calculate risk-adjusted returns via the Treynor method, follow this formula:
Treynor Ratio= (Average Investment Portfolio Return – Average Risk-Free Rate)/ Portfolio Beta
Using the Treynor ratio, investors can determine within their investments the degree of systematic risk and amount of returns to be earned depending upon the risks taken in an investment. Basing its findings on the historical data of an investment, investors can likely use the Treynor calculation to adjust actions or progress of investments according to successes within their previous finances.
By finding the right calculation for your investment plan and financial goals, more can be earned in risk-adjusted returns to substantiate a healthier, stable financial plan. To learn more about how you can passively invest in quality risk-adjusted real estate investments, contact CF Capital today to get in touch with our experienced team. Our team leverages its expertise in acquisitions and management to provide investors with superior risk-adjusted returns while placing a premium on preserving capital.
