What Is Risk Adjusted Return On Capital And How Do You Calculate it?

We have said this often enough, but it bears repeating.

There is no such thing as a risk-free investment.

We’ve said this, as well.

Due diligence before investing is of the utmost importance.

The difficulty, however, is that, when it comes to pre-investment research, risk can be highly difficult to quantify. Difficult, certainly, but not impossible. You can determine your target investment’s degree of risk by comparing it with other variables. This concept is known as risk-adjusted return, and it can help you:

• Compare risk between two or more investments
• Compare posted returns with those of a benchmarked index
• Measure the potential profit of an investment, relative to the amount of represented risk

Translating the above from investment-ese into English, risk-adjusted return calculations rely on ratios to analyze how much return your targeted investment has the potential to provide, compared to other investments, and relative to the potential amount of risk.

### Busting the Returns Fallacies

You might have read the word “ratios,” and then thought: “Nope. I don’t do math.”

If you take away anything from this discussion, it should be that risk-adjustment return ratios are in place to help you determine an investment’s risk, relative to other measures. But first, let’s delve a little deeper into how the risk-return adjustment concept busts some of the following returns fallacies.

Fallacy #1: Taking on more risk will lead to a higher return. This is not always true, as risk is highly unpredictable. While investors tend to require higher projected returns for riskier investments, the actual result of a high-risk investment could be a low, even negative return.

Fallacy #2: All deals are equal, so select the one with the highest projected cash-on-cash return. Again, not true. Investments’ risk can differ, based on numerous factors, which require careful examination. As such, the investment with the highest rate of return might not be suitable for you.

Fallacy #3: All types of risk will lead to a higher expected average return. Once again, false. There is no guarantee that any investment will lead to a higher return.

Risk-adjusted return calculations help you better pinpoint different types of risk that might impact a targeted investment, rather than relying on fallacies that might exert a negative impact on your portfolio and/or goals.

### A Review of Ratios

Now, on to some of the risk-return ratios your financial advisor might use to determine the risk/reward balance on your current and potential investments. What follows are not all the ratios, just some of those that are more frequently used.

Sharpe Ratio

The Sharpe Ratio measures an investment’s performance, then compares it to a predominantly risk-free investment. “Wait a minute,” you might be thinking. “Didn’t you just say that there is no such thing as a risk-free investment?” Our answer is: Very good. You were paying attention.

No investment is risk-free, but some come close, such as U.S. Treasury bills. So, the Sharpe Ratio will quantify your potential investment’s return against Treasury bills, using a standard deviation formula. Standard deviation explains the degree of investment risk, as measured against lower-risk investments.

Your financial professional will use the investment’s return, the risk-free rate, and standard deviation to calculate the Sharpe Ratio. If the calculation produces a number higher than 1, this represents a higher risk-to-return scenario of your investment.

Treynor Ratio

Also known as the reward-to-volatility ratio, the Treynor Ratio also compares investments against less-risky counterparts. However, unlike the Sharpe Ratio, this measurement tool relies on a beta coefficient, or volatility, to measure the risk.

The beta coefficient focuses on systemic risk -- in other words, the likelihood of a potential event that could lead to a system’s collapse or failure. While the Sharpe Ratio might determine that a specific investment has lower risk, compared to others, the Treynor Ratio could increase the degree of risk, based on system, or market, factors.

In calculating this ratio, your financial advisor will examine the investment’s return, risk-free rate, and beta (or historical movements of the market in which your investment is based). The higher the Treynor Ratio value, the higher the rate of return, with inclusion of other market risks. However, because this ratio is based on historical data, it doesn’t indicate future performance.

Jensen’s Alpha

Jensen’s Alpha or Jensen’s Measure, as it’s sometimes called, focuses on an investment’s average return, based on what might be predicted by the capital asset pricing model (CAPM), or the market movement, as a whole. This calculation takes into account the investment’s realized return, the realized return of the appropriate market index, the risk-free rate of return for a period of time, and the investment beta, relative to the selected market index. Anything above 1.1% alpha signifies that the investor might receive a high return for the risk.

### Behind the Ratios

It’s important to research financial instruments before you invest in them, and to keep track of them once they are in your portfolio. Understanding risk-adjusted returns can help you determine the degree of risk involved with investments you have and those you are targeting.

An investment isn’t inherently bad or good because of its degree of risk. Rather, knowledge of an investment’s risk/reward factors, relative to other issues, can help you better determine what will be most suitable for your portfolio and financial goals.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice, meeting the particular investment needs of any investor.

There is no guarantee that the investment objectives of any particular program will be achieved.

The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that they will be able to pay or maintain distributions, or that distributions will increase over time.