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Risks and Goals 2023

Understanding Risk-Adjusted Returns for Investing in 2023

Picture this: you’re an investor, navigating the vast landscape of the financial market, which direction to take, how to invest and in what- with the goal of achieving YOUR financial goals- all with the aim to maximize your returns while minimizing risk. But how can you make informed decisions that balance these two aspects? Think risk-adjusted returns, a trusted compass in the world of investing combined with your Goals. This comprehensive measure not only considers the return of an investment, but also the risk involved, giving you a fuller picture of an investment’s performance.

Short Summary

  • Risk-adjusted returns are an important measure for evaluating investments, taking into account potential rewards against risks.

  • Key metrics such as the Sharpe Ratio, Treynor Ratio and Sortino ratio help investors compare different investments.

  • Diversifying across asset classes and portfolio optimization techniques can help achieve optimal risk-adjusted returns.

  • Goals focused -What does all this mean to ME and my situation?

The Importance of Risk-Adjusted Returns in Investing

roller coaster, amusement park, sunset

Investing can sometimes feel like a wild rollercoaster ride. The exhilarating highs of high returns can often be followed by the stomach-churning lows of market downturns. That’s where risk-adjusted returns come into play. They serve as a measure of an investment’s return relative to its risk, allowing investors to compare investments with different risk levels.

Imagine you’re at a race track watching two cars zoom by. One car is driving at breakneck speed, while the other is moving at a more measured pace. The faster car might cross the finish line first, but it also runs a higher risk of crashing. Similarly, an investment might yield high returns, but it’s crucial to consider the risk taken to achieve those returns. This is exactly what risk-adjusted returns help you do.

Risk-Free Rate

In the world of investing, the term ‘risk-free rate’ is akin to the mythical unicorn. It represents the return on an investment with no risk - usually government bonds. This magical number serves as a benchmark for figuring out risk-adjusted returns and helps investors manage market volatility.

In the investing world, the risk-free rate represents Treasury bills, that usually yield around 5% annually and are often used as a risk-free rate when calculating risk-adjusted returns.

Higher Risk-Adjusted Return vs. Higher Absolute Return

When it comes to investing, judging an investment purely by its absolute return is like judging a book by its cover. It’s the deeper story that matters – the risk involved in achieving those returns. A higher risk-adjusted return takes into account the level of risk involved in an investment, while a higher absolute return just looks at the total return without considering the risk.

Let’s say you’re choosing between two hiking trails. One is a steep, treacherous path with a glorious view at the top, while the other is a gentle stroll with a pleasant, but less spectacular view. The first trail might offer a higher ‘absolute return’ (the view), but it comes with more risk (a difficult climb). The second trail offers a lower ‘absolute return’ but with less risk.

Similarly, in investing, it’s essential to weigh the potential rewards against the risks involved and consider how much risk to take on in order to achieve a higher risk-adjusted return.

Key Metrics for Evaluating Risk-Adjusted Returns

enigma, encryption, cryptologic

Risk-adjusted returns can be a bit like a secret code. To crack this code, you need the right tools. These tools that are often used are key metrics such as the Sharpe Ratio, Treynor Ratio, Jensen’s Alpha, and Sortino Ratio, which help evaluate risk-adjusted returns. Think of these metrics as the compass, map, binoculars, and multi-tool of your investing journey.

Each tool provides a different perspective and helps you navigate the complex terrain of investing. They allow you to evaluate how effectively your investment, or a fund you’re considering investing in, is generating returns relative to the risk taken.

Sharpe Ratio

The Sharpe Ratio is perhaps the most widely used. Created by Nobel laureate William F. Sharpe in 1966, this measure calculates the excess return per unit of risk, with higher ratios indicating better risk-adjusted performance.

Imagine you’re choosing between two tour guides for a jungle adventure. Both promise an equally exciting experience, but one has a history of getting lost! You’d definitely choose the guide with a better track record, right? In the investing world, the Sharpe Ratio helps you make a similar decision. It measures the excess return (the excitement) for each unit of risk (the chance of getting lost). A higher Sharpe Ratio suggests that the excess returns are due to smart investing, and not just taking on too much risk.

Treynor Ratio

The Treynor Ratio is another useful tool in your investing toolkit. The returns can be calculated on an investment that has no diversifiable risk.

Picture this: you’re at a fruit market, comparing apples and oranges. Sure, they’re both fruit, but they have different tastes, textures, and nutritional benefits. The Treynor Ratio helps you make a similar comparison between investments, taking into account the different market risks each investment carries. A high Treynor Ratio suggests that an investor has earned high returns for each of the risks they’ve taken on.

Jensen's Alpha

If you’re looking for a way to measure investment performance compared to a market index benchmark, Jensen’s Alpha is your go-to metric. Named after its creator, Michael Jensen, this measure considers the risk-free rate, the security or portfolio’s beta (or market risk), and its actual realized return.

Let’s say you’re trying to decide between two chefs to cater your event. Both have great reviews, but one has consistently outperformed the other in head-to-head competitions. You’d likely choose the chef with the proven track record, right? Jensen’s Alpha works in a similar way, allowing you to identify investments that have outperformed the market’s expected return, considering the level of risk involved.

Sortino Ratio

The Sortino Ratio, named after Frank A. Sortino, is yet another tool in the investor’s toolbox. It goes a step further than the Sharpe Ratio by focusing only on the negative deviation of returns, providing a measure of an investment’s return for a given level of downside risk.

To illustrate, imagine you’re a judge in a singing competition. You’re not just interested in how high the contestants can hit the notes; you’re also concerned about how badly they miss the low notes. The Sortino Ratio works similarly, considering not just the potential upside of an investment, but also the potential downside risk. This way, it provides a more realistic measure of risk-adjusted performance, especially for investors who care more about downside risk.

Comparing Investment Funds Using Risk-Adjusted Returns

compare, comparison, scale

Moving on from the tools, let’s explore the terrain where they are applied - the world of investment funds. Risk-adjusted returns are like a GPS, guiding investors through the maze of investment funds. By using risk-adjusted returns, investors can compare funds, taking into account the benefits of diversification and the importance of analyzing fund performance.

Imagine you’re in a city with a vast array of food trucks, each offering a different cuisine. You want to try them all, but you can’t eat everything! You need to make a choice based on your taste preferences, budget, and dietary restrictions. Similarly, with investment funds, you need to make decisions based on your financial goals, risk tolerance, and market conditions. Risk-adjusted returns help you make these decisions by providing a more comprehensive picture of each fund’s performance.

Diversification Benefits

Investing can be a bit like a buffet - it’s best not to load up your plate with just one dish. Diversification is the practice of spreading your investments across different asset classes to reduce risk and potentially increase returns.

Let’s say you’re planning a road trip. You wouldn’t just pack one type of clothing, right? Just as you’d pack a variety of clothes to be prepared for different weather conditions, diversifying your investment portfolio helps you weather the storms of market volatility. It balances out the potential losses of one asset class with the potential gains of another, helping you stay on track towards your financial goals.

Analyzing Fund Performance

Analyzing fund performance is like checking the health of your investments. Using risk-adjusted return metrics allows investors to evaluate the performance of different funds while taking into account the associated risk. This way, investors can make more informed decisions about which funds to invest in.

Think of it like a regular health check-up. Just as a doctor uses different metrics to evaluate your health, investors use these metrics to assess the health of their investment portfolio. The Sharpe Ratio, Treynor Ratio, Jensen’s Alpha, and Sortino Ratio serve as key indicators, helping investors understand whether their investments are on track to meet their financial goals.

Strategies for Achieving Optimal Risk-Adjusted Returns

kitchen scale, weighing, baking

Now that we’ve talked about the tools and the terrain, let’s talk strategy. Diversifying and allocating assets are two popular methods for getting the best returns while managing risk. Having a good mix of investments can help reduce the overall risk of portfolios, which could result in higher returns with less risk.

Think of it like baking a cake. You wouldn’t just throw all the ingredients into a bowl and hope for the best. You need to carefully measure and mix the ingredients to achieve the perfect balance of flavors. In a similar vein, asset allocation and portfolio optimization are two strategies that help investors achieve the perfect balance of risk and return in their investment portfolios.

Asset Allocation Decisions

Asset allocation decisions involve spreading out your investment portfolio among different asset categories, like stocks, bonds, and cash equivalents, to balance risk and reward according to your financial goals, risk tolerance, and investment timeline.

Imagine you’re planning a trip. You wouldn’t spend all your time in one place, right? You’d plan different activities and visit different places to make the most of your trip. Similarly, asset allocation involves diversifying your investments across different asset classes to reduce risk and potentially increase returns.

Portfolio Optimization Techniques

Portfolio optimization techniques are a bit like a GPS for your investment journey. They help you find the most efficient route to your financial goals. These techniques use risk-adjusted return metrics to identify efficient combinations of assets for a given level of risk or return.

Imagine you’re planning a road trip. You wouldn’t just pick a random route, would you? You’d use a GPS to find the most efficient route to your destination. Similarly, portfolio optimization techniques help you find the most efficient combination of investments to reach your financial goals, considering your risk tolerance and desired level of return.

Challenges and Limitations of Risk-Adjusted Return Metrics

limits, push, man

While risk-adjusted return metrics are a powerful tool in an investor’s toolbox, they’re not without their challenges and limitations. These metrics involve certain assumptions and simplifications that may not always hold true, making accurate risk measurement a tough nut to crack.

Imagine you’re trying to predict the weather. You might have all the fancy tools and data at your disposal, but there’s always a chance that your prediction could be off. The same is true for risk-adjusted return metrics. Although they provide valuable insights, they are not foolproof and should be used in conjunction with other investment analysis tools and strategies.

Assumptions and Simplifications

Assumptions and simplifications are like the shortcuts we take when navigating a complex maze. They can make our journey easier, but they don’t always lead us to the right destination. Risk-adjusted return metrics often involve assumptions and simplifications, which are not always accurate in reality. Such simplifications may lead to inaccurate outcomes.

Imagine you’re building a model of a city. You’d simplify the buildings, roads, and landmarks to make the model manageable. But in doing so, you might miss out on some details. Similarly, the assumptions and simplifications made in the models of risk-adjusted return metrics may not always accurately reflect the market’s volatility, limiting their usefulness in certain situations.

Measuring Risk Accurately

Measuring risk accurately is like trying to capture a moving target. The complexity of different types of risk and the potential for incomplete risk profiles can make this a challenging task.

Imagine you’re trying to shoot a moving target. It’s not just about aiming and firing; you also need to account for the target’s speed and direction, wind conditions, and other factors. Accurately measuring risk in investing is a similar challenge, due to the complexity of different types of risk and the potential for incomplete risk profiles.

Real-World Examples of Risk-Adjusted Return Analysis

people, hand, company

After navigating through the maze of risk-adjusted returns, let’s take a look at some real-world examples. From evaluating stock or corporate bond investments to understanding the impact of market volatility on investment decisions, risk-adjusted return analysis provides valuable insights for investors.

Consider this: you’re deciding between two travel destinations. One is a bustling city with lots to do and see, but it’s also more expensive and crowded. The other is a quiet countryside retreat - less expensive and less crowded, but also with fewer attractions. Risk-adjusted return analysis in investing is similar. It helps you weigh the potential returns (the attractions) against the risks (the costs and crowds) to make informed investment decisions.

Stock or Corporate Bond Investments

Let’s dive deeper and look at stock or corporate bond investments. Investing in stocks means you’re buying a piece of a company, while corporate bonds mean you’re lending money to the company and getting interest payments in return.

Just like deciding between a rollercoaster ride or a relaxing boat cruise at an amusement park, choosing between stock or corporate bond investments depends on your risk tolerance and investment objectives. Risk-adjusted return metrics can be a great way to evaluate these investments, as they help you consider both returns and risks to spot attractive opportunities.

Market Volatility and Investment Decisions

Market volatility is like the weather - it can change rapidly and have a significant impact on your plans. Understanding market volatility is crucial for making informed investment decisions.

By using risk-adjusted return metrics, investors can manage volatility and calculate risk-adjusted returns on a risk adjusted basis to determine if their investment strategies are generating appropriate risk adjusted return measures.

How does this mean to me?

poses, female, education

The above tools are nice to know about, but in reality, many people are going to say, "that's nice" but what does it mean- how can I utilize this?

People need to view their financial picture as it relates to them and their situation- not someone down the street or the folks you hear about in the news and having their assets risk align with those goals.

What are your Goals? When do you want to achieve them? What is it that you want to do? And having your investments align with those goals is a fundamental part of risk adjusted returns. If you have enough to achieve the goal, why keep it at Risk? If you are struggling to build the nest egg and have some time, keeping it in a savings account probably is not prudent either.


In the journey of investing, risk-adjusted returns serve as a compass, guiding investors towards informed decisions. From understanding the importance of risk-adjusted returns, navigating through key metrics, comparing investment funds, to outlining strategies for optimal risk-adjusted returns, we’ve journeyed through the multifaceted landscape of risk-adjusted return analysis. Despite its challenges and limitations, it remains a crucial tool in an investor’s toolbox. Combining Risk Adjustments with your goals helps protect the money that you have worked hard for and hopefully have the money work for you.

Frequently Asked Questions

What is investing in simple terms?

Investing involves using money to try and generate more money, as opposed to saving which is usually done with the aim of having a secure reserve of money available.

What are some financial goals examples?

Financial goals examples could include signing up for a retirement plan, funding a vacation, resolving student loan debt, becoming a homeowner, launching a business, paying college tuition, reserving money for emergencies, finding a higher-paying job and more.

These goals can be achieved through careful budgeting, saving, and investing. Setting financial goals can help you stay motivated and focused on achieving your desired outcome. It can also help you prioritize your spending and make sure you are making the most of your money.

Please reach out with any questions- Paul Doak, CFP(R)

Check the background of this financial professional on FINRA's BrokerCheck
Check the background of this financial professional on FINRA's BrokerCheck