What is RAR, who needs it, and how to calculate it
By David M. Freedman.
Are you earning higher returns on riskier investments? You don't really know unless you calculate your risk-adjusted returns.
Risk-adjusted return (RAR) is a measure of the return on an investment relative to the risk of that investment, over a specific period. You can also measure the risk-adjusted return on a fund, a portfolio, or a group of similar investments—similar in terms of risk, that is.
The calculation is not simple. It involves making assumptions about a risk-free rate of return, selecting portfolio and market benchmarks, figuring the standard deviation of return, and/or using “beta” (a separately calculated figure that describes the tendency of an investment to respond to marketplace swings).
Unless you’re a financial analyst, you might think that’s more than you need to know. But for those who are still curious, I’ll provide a simplified explanation, and then give you some resources for studying risk-adjusted return further.
A Simplified Explanation of Risk-Adjusted Return
Let’s say you invest in two different stocks, A and B. You believe that because A is a bigger, older company with consistent profit growth and returns on equity, and B is much smaller and younger and more volatile, B is riskier than A. So why did you invest in B if it’s riskier? The reason is that you believe B might grow faster than A in terms of profitability and/or stock price. In other words, as compensation for bearing more risk, you expect a higher return on your investment in B.
Let’s say that after a few years, your portfolio statement shows that the returns on A and B are exactly the same. You might conclude that you would have been smarter to invest all that capital in A, because it would have been less risky. Your willingness to bear greater risk was not rewarded by a greater return.
Stated another way, if two investments had the same return over a specific period, the less risky asset would have a better RAR.
On the other hand, let’s say that after a few years, B has outperformed A spectacularly. You may conclude that you were very well compensated for the risk you assumed.
Let’s look at a more common scenario, in which B slightly outperformed A in terms of the return on investment. Can you now definitively say that the risk you took on your investment in B was rewarded by a commensurately better return? Not unless you measure your risk-adjusted returns of both A and B. To reiterate, risk-adjusted return is a measure of the return (of a single asset or a group of similar assets) in relation to the risk.
Diversification Benefit Balances Risk
As I said, that explanation is simplified. It might not be fair to assume that investing in B increased your risk. In fact, investing in both A and B is more diversified than investing solely in A, and diversification helps to minimize risk. Another real-world scenario is that B may have served as a hedge for A, another risk-reducing strategy. Or both are strategically related to other assets in your portfolio.
Modern portfolio theory holds that you must consider the risk of an asset in terms of how its addition to a portfolio affects the risk level of the entire portfolio. That’s known as the diversification benefit of an asset.
Furthermore, calculating risk-adjusted return might be useful as a measure of past performance, but it does not necessarily predict future performance reliably.
3 Methods of Measuring RAR
Now it gets even more complicated. There are a few different ways to measure risk-adjusted return, and the best way depends on the characteristics of the assets you’re measuring and the portfolio the assets are in.
As a generality, if your portfolio represents your entire investment, or if your portfolio contains mostly non-financial assets, the Sharpe ratio is best to measure risk-adjusted return.
If your portfolio includes many disparate assets and asset classes, or if you are measuring only one asset, then Jensen’s alpha or the Treynor ratio may be best, depending on such variables as diversifiable vs. non-diversifiable risk.
David M. Freedman (www.freedman-chicago.com) is a financial and legal journalist based in Chicago. He is coauthor of Equity Crowdfunding for Investors (Wiley & Sons, NY, 2015). This article originally appeared at Financial Poise, an e-zine that provides reliable plain English business, financial, and legal education to individual investors, entrepreneurs, business owners, and executives.