What Is a Risk-Adjusted Return?
A risk-adjusted return measures the profitability of an investment after accounting for the risk required to achieve it.
In simple terms, it tells you how much reward you earned for the risk you took.
Two investors may both earn 10%, but if one took on significantly more volatility or downside exposure, their return is less efficient.
By calculating risk-adjusted returns, analysts can compare investments “apples to apples”, even when they differ in size, type, or market exposure.
The risk-free rate—typically the yield on a 10-year U.S. Treasury bond—is used as a benchmark.
Returns above this rate are considered excess returns, which are then adjusted based on the level of risk taken.
Why Risk-Adjusted Returns Matter
In investing, higher risk doesn’t always mean higher reward.
The goal isn’t just to maximize returns, but to maximize efficiency — earning the best possible return per unit of risk.
Risk-adjusted returns allow investors to:
- Compare different funds or portfolios with varying levels of volatility.
- Identify overly risky investments that don’t compensate sufficiently.
- Evaluate portfolio managers’ performance relative to the market.
- Make informed asset allocation and rebalancing decisions.
In professional portfolio management, risk-adjusted metrics are vital for performance attribution and strategic diversification.
Common Methods to Measure Risk-Adjusted Return
1. Sharpe Ratio
The Sharpe Ratio, developed by William F. Sharpe, is the most widely used risk-adjusted measure.
It calculates excess return per unit of total risk, where total risk is represented by standard deviation.
Formula: Sharpe Ratio=(Rp−Rf)σpSharpe\ Ratio = \frac{(R_p – R_f)}{\sigma_p}Sharpe Ratio=σp(Rp−Rf)
Where:
- RpR_pRp = Portfolio Return
- RfR_fRf = Risk-Free Rate
- σp\sigma_pσp = Standard Deviation of Portfolio Returns
Interpretation:
- Higher Sharpe ratios (>1) indicate better risk-adjusted performance.
- A Sharpe ratio <1 suggests the return does not adequately compensate for risk.
Example:
If a fund earned 12%, the risk-free rate was 3%, and volatility was 10%, Sharpe=(12−3)/10=0.9Sharpe = (12 – 3) / 10 = 0.9Sharpe=(12−3)/10=0.9
2. Treynor Ratio
The Treynor Ratio, created by Jack L. Treynor, focuses on systematic risk (market risk) rather than total volatility.
It measures the return earned per unit of beta, showing how well an investment compensated investors for exposure to overall market risk.
Formula: Treynor Ratio=(Rp−Rf)βpTreynor\ Ratio = \frac{(R_p – R_f)}{\beta_p}Treynor Ratio=βp(Rp−Rf)
Where:
- βp\beta_pβp = Portfolio Beta (sensitivity to market movements)
Example:
If a portfolio earns 10%, with a risk-free rate of 3% and a beta of 0.75, Treynor=(10−3)/0.75=9.33Treynor = (10 – 3) / 0.75 = 9.33Treynor=(10−3)/0.75=9.33
Interpretation:
A higher Treynor ratio means the investor is being better compensated for each unit of market risk.
3. Sortino Ratio
The Sortino Ratio refines the Sharpe ratio by focusing only on downside risk — volatility from negative returns.
It ignores upside fluctuations, which are beneficial to investors.
Formula: Sortino Ratio=(Rp−Rf)σdSortino\ Ratio = \frac{(R_p – R_f)}{\sigma_d}Sortino Ratio=σd(Rp−Rf)
Where:
- σd\sigma_dσd = Downside Deviation (volatility of negative returns)
Example:
A fund returns 16%, has a downside deviation of 9%, and a risk-free rate of 3%: Sortino=(16−3)/9=1.44Sortino = (16 – 3) / 9 = 1.44Sortino=(16−3)/9=1.44
Interpretation:
A higher Sortino ratio means the portfolio generates better returns per unit of downside risk — making it a preferred tool for conservative investors.
4. Jensen’s Alpha
Jensen’s Alpha, or simply Alpha, measures a portfolio’s performance relative to its expected return based on its risk (beta).
It shows whether the manager outperformed or underperformed the market on a risk-adjusted basis.
Formula: α=Rp−[Rf+βp(Rm−Rf)]\alpha = R_p – [R_f + \beta_p (R_m – R_f)]α=Rp−[Rf+βp(Rm−Rf)]
Where:
- RmR_mRm = Market Return
Interpretation:
- α > 0: Portfolio outperformed its benchmark
- α = 0: Portfolio performed in line with expected risk-return
- α < 0: Portfolio underperformed for its level of risk
5. Modigliani–Modigliani (M²) Measure
The M² Measure translates risk-adjusted performance into percentage terms, making it easier to interpret than ratios.
It compares an investment’s risk-adjusted return directly to a market index.
Formula: M2=Rpadjusted−RmM^2 = R_p^{adjusted} – R_mM2=Rpadjusted−Rm
Where:
- RpadjustedR_p^{adjusted}Rpadjusted = Portfolio Return adjusted for market risk
- RmR_mRm = Market Return
Example:
If the adjusted portfolio return is 15% and the market return is 10%, M2=5%M^2 = 5\%M2=5%
This indicates the portfolio outperformed the market by 5% on a risk-adjusted basis.
Comparing the Ratios: Which One to Use?
| Metric | Risk Focus | Best Used For |
|---|---|---|
| Sharpe Ratio | Total volatility | Overall portfolio performance |
| Treynor Ratio | Systematic (market) risk | Diversified portfolios |
| Sortino Ratio | Downside risk | Conservative investors |
| Jensen’s Alpha | Expected return vs. benchmark | Evaluating fund managers |
| Modigliani–Modigliani (M²) | Risk-adjusted excess return | Simple performance comparison |
Each ratio highlights a unique aspect of performance.
Professional analysts often use multiple metrics together to capture both total and downside risk dynamics.
Practical Example of Risk-Adjusted Comparison
Consider two mutual funds:
| Fund | Annual Return | Std. Deviation | Beta | Downside Deviation |
|---|---|---|---|---|
| Fund A | 12% | 10% | 0.9 | 8% |
| Fund B | 10% | 7% | 0.75 | 6% |
Assume the risk-free rate is 3%.
| Ratio | Fund A | Fund B | Winner |
|---|---|---|---|
| Sharpe | 0.9 | 1.0 | B |
| Treynor | 10% | 9.3% | A |
| Sortino | 1.13 | 1.17 | B |
Interpretation:
Fund B offers better efficiency on total and downside risk, while Fund A delivers superior compensation for systematic (market) risk.
Such analysis helps investors align investments with their risk tolerance and strategy goals.
Limitations of Risk-Adjusted Metrics
While risk-adjusted ratios are invaluable, they have limitations:
- Historical bias: Most rely on past data, not forward-looking projections.
- Volatility ≠ risk: Ratios assume that all volatility is bad, which isn’t always true.
- Context dependency: Ratios must be compared within the same timeframe and market conditions.
- Data sensitivity: Small changes in returns or standard deviation can skew ratios.
Thus, risk-adjusted returns should complement — not replace — fundamental analysis, diversification, and long-term strategy.
Bottom Line
Risk-adjusted return is the cornerstone of smart investing.
It bridges the gap between raw performance and risk exposure, ensuring investors know not just how much they earn — but how efficiently they earn it.
Whether using the Sharpe, Treynor, Sortino, or M², understanding these ratios empowers investors to:
- Evaluate portfolio efficiency
- Compare funds fairly
- Optimize risk-reward balance
In essence, higher risk-adjusted returns signify smarter, more disciplined investing — the key to sustainable wealth creation.
