Risk adjusted return: an emphatic utterance often thrown about in the investment world. But what does it really mean and how is it relevant?
To give a meaningful definition we must first back-up and consider what we call absolute return. Absolute return is how much money you made. As an example: this year, my portfolo made 4%. This is what we tend to naturally focus on. Investment firms are equally prone to touting absolute returns, especially in years where they've performed exceptionally well. In a way, that seems fair. After all, isn't it the bottom-line number that counts? But what if the high return on my portfolio was achieved while employing undue risk? Having that piece of information changes the way I feel about things. When we give thought to what level of risk was taken in order to achieve a return, we are considering the risk-adjusted return.
When evaluating performance, the level of risk taken should be taken into consideration.
One final thought, it is tempting to see how our portfolio returns stack up in relation to others. But once we begin to understand and apply the concept of the risk-adjusted return we realize that other clients' circumstances including their risk tolerance are unique to them and that drawing such comparisons is not necessarily helpful.
This is another benefit to understanding the risk-adjusted return: we gain knowledge and wisdom that enable us to make more meaningful judgments.
So, what's the bottom line in all of this? Return, considered alongside the risk that was taken to get there, allows for a more informative assessment to be made. A high return in and of itself is certainly desirable, but a high return alongside high risk can be a dangerous game to play whereas a consistent rate of return achieved while employing the minimum amount of risk necessary is prudent and wise. All things considered, a decent risk-adjusted return comes with one final intangible that you can't put a price on: Peace of Mind.