Risk-Adjusted Return
A measure of investment return that accounts for the amount of risk taken to achieve it, enabling fair comparison across investments.
What is Risk-Adjusted Return?
A risk-adjusted return modifies a portfolio's raw return to reflect the amount of risk incurred in generating that return, allowing investors to compare investments with different risk profiles on equal footing. An investment that earned 15% by taking extreme risk may be inferior to one that earned 10% with moderate risk. Common risk-adjusted metrics include the Sharpe ratio (excess return per unit of total volatility), the Sortino ratio (excess return per unit of downside volatility), and Jensen's alpha (excess return versus a benchmark adjusted for beta). Risk-adjusted return is the fundamental concept behind portfolio optimization and manager evaluation.
Example
Fund A returned 12% last year by holding a concentrated portfolio in volatile small-cap stocks (standard deviation 30%). Fund B returned 9% with a diversified portfolio (standard deviation 10%). Fund A's Sharpe ratio was 0.33; Fund B's was 0.75. On a risk-adjusted basis, Fund B delivered superior performance.