What Is Risk‑Adjusted Return?
Risk‑adjusted return measures how much return you earn relative to the risk you take. It answers: “Am I being rewarded fairly for the risk in my portfolio?”
Why Risk‑Adjusted Return Matters
- Raw returns are misleading: 12% with huge volatility is not the same as 12% with stability.
- Compare fairly: Risk‑adjusted metrics level the playing field between assets.
- Prevent chasing risk: High returns can hide extreme risk.
- Improve long‑term outcomes: Efficient portfolios compound more smoothly.
- Optimizer ranking: Your tool uses risk‑adjusted return to score and rank portfolios.
How Risk‑Adjusted Return Is Measured
Several metrics measure risk‑adjusted return. The most common include:
1. Sharpe Ratio (Most Popular)
2. Sortino Ratio (Downside‑Focused)
3. Treynor Ratio (Beta‑Adjusted)
4. Information Ratio
Simple Examples
Example 1 — Same return, different risk
Portfolio A: Return 10%, Volatility 5% → Sharpe ≈ 2.0
Portfolio B: Return 10%, Volatility 20% → Sharpe ≈ 0.5 — Portfolio A is 4× more efficient.
Example 2 — Higher return, worse efficiency
Portfolio C: Return 15%, Volatility 30% → Sharpe ≈ 0.5
Portfolio D: Return 10%, Volatility 8% → Sharpe ≈ 1.25 — Portfolio D is more efficient despite lower raw
return.
Example 3 — Crypto allocation
Portfolio E: Return 20%, Volatility 60% → Sharpe ≈ 0.33
Portfolio F: Return 12%, Volatility 15% → Sharpe ≈ 0.8 — Portfolio F is far more stable and easier to
hold.
Why Risk‑Adjusted Return Improves Long‑Term Investing
- Smoother compounding: lower volatility reduces volatility drag from drawdowns.
- Survivability: Higher‑Sharpe portfolios typically fall less in crashes and recover faster.
- Less emotional selling: Investors stay invested through volatility when returns are efficient.
- Aligned with behavior: Most people prefer predictable growth over wild swings.
Risk‑Adjusted Return and Diversification
Diversification reduces volatility and correlation, improving risk‑adjusted return (e.g., Sharpe). This is why diversified portfolios often outperform concentrated ones on a risk‑adjusted basis.
Risk‑Adjusted Return and the Efficient Frontier
The efficient frontier is constructed from risk and expected return; every point on the frontier represents the best risk‑adjusted trade‑off for a given level of risk. The maximum‑Sharpe (tangent) portfolio sits at the top of the frontier.
How Your Optimizer Uses Risk‑Adjusted Return
- Ranks portfolios by efficiency and identifies inefficient allocations.
- Explains why a portfolio is efficient or not using diagnostics and visualizations.
- Builds the efficient frontier and computes the maximum‑Sharpe portfolio.
- Suggests rebalancing or allocation changes to improve risk‑adjusted performance.
How to Interpret Risk‑Adjusted Return
- Low efficiency: High volatility, large drawdowns, hard to hold emotionally.
- Moderate efficiency: Balanced and suitable for long‑term investors.
- High efficiency: Smooth returns, strong diversification, excellent risk‑adjusted performance.
FAQ
Is risk‑adjusted return more important than raw return?
Yes — it gives a more complete picture of portfolio quality by accounting for the cost of risk.
What is a good risk‑adjusted return?
Sharpe above 1.0 is good; above 2.0 is excellent. Context and timeframes matter.
Does diversification improve risk‑adjusted return?
Almost always — diversification lowers volatility and can increase metrics like Sharpe.
Can risk‑adjusted return be negative?
Yes — a negative value means the portfolio underperformed the risk‑free rate on a risk‑adjusted basis.
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