Risk-Adjusted Return Ratios
Risk is the degree of uncertainty and potential financial loss in an investment.
What are the Risk-Adjusted Return Ratios?
Risk-adjusted return ratios assess an investment's profitability relative to its risk level, which is crucial for investors evaluating potential ventures.
By considering factors like volatility and uncertainty, these ratios provide insights into how well an investment performs in relation to the risks involved, aiding in informed decision-making and portfolio management.
Risk is the term used in finance to describe the degree of uncertainty and potential financial loss in an investment. Investors typically want higher returns when investment risks increase.
Every financial instrument has varied risks and returns associated with it.
Types of Risk
Before going into Risk-adjusted ratios, let us look at various types of risks involved in an investment.
Business Risk
Business risk term is used to address the possibility of failure in operational activities of the business. There are many reasons a company's operations might get affected. These factors are divided into two parts - Internal and external risks.
Internal Risks: Factors that can be controlled.
- Human Capital
- Inventory
- Working Capital Management
External Risks: Factors that cannot be controlled
- Macroeconomic Conditions
- Natural Factors
- Policy Changes
Credit Risk
Credit risk is the potential for a borrower to default on a debt by skipping payments. The lender's risk, which includes lost principal and interest, disruption of cash flows, and higher collection expenses, comes into play in the first instance.
There could be a whole or partial loss. Higher credit risk will result in higher borrowing rates in a competitive market. As a result, based on evaluations by market players, measures of borrowing costs, such as yield spreads, can be used to infer credit risk levels.
Currency Risk
Currency risk, also known as exchange rate risk, is the exposure that comes with investing in foreign markets or doing business with foreign companies in terms of unforeseen gains or losses brought on by fluctuations in the value of one currency relative to another.
Equity Risk
The financial risk associated with owning equity in a particular investment is known as equity risk.
Equity risk most frequently refers to the risk of investing in firms by purchasing stocks; it does not frequently refer to investing in real estate or accumulating equity in assets. Nevertheless, an aspect of market risk that concerns stock investments is equity risk.
The supply and demand factors constantly affect the market price of stocks. Therefore, equity risk is the possibility of losing money if the market price of shares declines.
Foreign Investment Risk
The risk of losing money when investing in foreign nations is known as foreign investment risk. This includes any investment with a company not based in your country, including buying stock in foreign corporations.
Currency, political, and interest rate risks are possible, although they might not impact similar investments in your country.
Inflation Risk
A consistent rise in prices is referred to as inflation. For investors receiving a fixed interest rate, inflation diminishes their actual rate of return. As a result, inflation is one of the biggest concerns for people who hold cash equivalents.
Interest rate risk
A bond's value may alter as interest rates fluctuate. This is because the face value of the bonds, plus interest, will be paid to the holder if they are held until maturity. Therefore, the bond's value could be more or lower than its face value if sold before it matures.
When interest rates rise, new bonds will be more tempting to investors because they will pay a greater interest rate than older bonds. As a result, you might need to sell a more senior bond at a discount if you want to sell it because it has a lower interest rate.
Liquidity risk
This refers to the possibility that investors won't be able to sell their securities when they want to due to a lack of a market for them. With the more complex investment products, this may be the case.
It might also apply to goods like certificates of deposit that have penalties for early withdrawal or liquidation (CD).
Volatility Risk
The value of investments such as portfolios and derivatives may be unpredictable because of the unpredictability of the tied assets. This risk of value change is called volatility risk. The critical thing to note is the higher risk arises from a more significant difference in the price value.
Why do we need risk-adjusted ratios?
You should consider both the risk taken and the returns created by the investments when comparing the performance of two assets or checking your portfolio's returns. You can measure the same using risk-adjusted returns.
It assesses the amount of risk taken to earn a return to calculate the return on investment. Comparing multiple individual equities, mutual funds, and portfolios using risk-adjusted returns is helpful.
These ratios help compare investment strategies and rank them.
Risk-Adjusted Return Ratios – Sharpe Ratio
Sharpe Ratio is used to calculate the excess amount of returns on the risky financial assets held. As we all know, in finance, it is a common saying that the more complex the investment, the higher its returns should be.
This ratio uses the asset's volatility risk to estimate a strategy's credibility. Here's the formula for Sharpe ratio calculation:
Sharpe Ratio = (Rp - Rf)/ (std dev.)
- Rp is the return on the portfolio
- Rf is a risk-free return rate.
Generally, the risk-free rate is the shortest dated U.S. Treasury. The other way of estimating a risk-free rate is by looking for risk-free security of a similar duration as that of the asset.
Std dev is the standard deviation of the portfolio's excess return.
The issue with this is that this ratio doesn't consider leverage and active portfolio management. This ratio is also accurate only when the return data is a normal distribution.
Risk-Adjusted Return Ratios – Treynor Ratio
Treynor Ratio, also known as the reward-to-volatility ratio, calculates the excess returns earned compared to the portfolio's Beta. Here's a formula to calculate Treynor Ratio:
Treynor Ratio = (Rp - Rf)/ beta
- Rp = Portfolio return
- Rf = Risk-free return
- Beta = portfolio’s beta
Similar to Sharpe Ratio, this ratio doesn't consider active portfolio management.
Risk-Adjusted Return Ratios – Jensen’s Alpha
Jensen's Alpha measures how better the strategy performs compared to the benchmark portfolio with a similar market risk involved. This ratio focuses on active management.
The formula to calculate Jensen's Alpha:
Jp = Rp - (Rf + beta * (Rm-Rf))
Where,
- Jp is Jensen's alpha
- Rp = Expected Portfolio Return
- Rf = Risk-free Rate
- Beta = Beta of the portfolio
- Rm = Expected market returns
- Rm - Rf = Risk Premium
The Jensen alpha < 0 indicates that the investment has earned less than its risk.
Jensen alpha = 0 indicates that the return is adequate for the risk involved.
Jensen alpha > 0 indicates the reward-to-risk ratio of the strategy is high. Hence it is a good range.
Risk-Adjusted Return Ratios – R-Squared
The R-Squared measures the percentage of a fund's movements based on the direction of the benchmarked index. The ratio can have values between 0 and 1.
When the R-Squared value is 1, the fund's movements can be explained by changes in the benchmarked index.
Risk-Adjusted Return Ratios – Sortino Ratio
This is a modification to the Sharpe ratio. It splits the return on a portfolio by the "Downside Risk." The volatility of a portfolio's return below a specific threshold is known as downside risk.
Average returns determine the threshold.
The ratio gauges a stock's or fund's downside risk. Higher values, similar to the Sharpe ratio, suggest a lower risk of returns.
The only difference between Sharpe Ratio and Sortino Ratio is the denominator in their formula; for Sortino, we take the standard deviation of a negative asset return, while for Sharpe Ratio, it is a simple standard deviation of returns. Here's a mathematical formula to calculate Sortino Ratio:
Sortino Ratio = (Rp - Rf)/ (std dev)
Where,
- Rp = Portfolio Return
- Rf = Risk-free rate
- Std dev = Standard deviation of negative asset return
Risk-Adjusted Return Ratios – Modigliani-Modigliani Measure
The risk-adjusted return on investment is calculated using the Modigliani-Modigliani measure, or M2. It displays the investment return on a risk-adjusted basis about a benchmark. Here's the formula to calculate Modigliani Modigliani measure:
M2 = Rp - Rm
where,
- Rp = Portfolio return
- Rm = Benchmark market return
Other Terms Used in Risk Management
Some of the terms used in risk management are:
Value at Risk
Over the years, VaR has also gained popularity as one of the risk measures. For example, Value at Risk (VaR) is a metric used to quantify investment loss risk.
It calculates the potential loss of a group of investments over a specified period, such as a day, given typical market conditions and a particular likelihood.
Firms and authorities in the financial sector frequently utilize VaR to determine the number of assets required to cover potential losses.
The p VaR can be mathematically defined as the maximum loss possible over that time after rejecting all worse events whose joint probability is at most p for a given portfolio, time horizon, and probability p.
This presupposes mark-to-market pricing and a portfolio free of transactions. For instance, if a portfolio of equities has a one-day 95 percent VaR of $1 million, it has a 0.05 likelihood of losing more than $1 million in value over a single day if there is no trading.
Hence, 1 out of 20 days should result in a loss of $1 million or more on this portfolio (because of a 5 percent probability). So here's a way to calculate Value at Risk for your portfolio:
VaR = Alpha * (Std dev) * Asset Value * (Time Scaling)
It should be noted that the VaR and Valuation risk are entirely different terms.
Conditional Value at Risk
VaR has been Modified to a more sophisticated method - CVaR (Conditional Value at Risk).
The extended risk measure of value-at-risk, known as conditional value-at-risk (CVaR), measures the average loss over a certain period of implausible events over the confidence level. This is extensively used for portfolio optimization.
Drawdown
Drawdown is simply the percentage of the amount of decline the portfolio saw from its peak. Traders try to reduce the Drawdown as much as possible. Controlling the Drawdown helps reduce the volatility or the risk involved in the strategy.
How is the risk an opportunity?
In finance, taking on greater risk increases your chances of making more money from your investments, i.e., the return should be proportional to the risk involved.
Therefore, don't just disregard an investing opportunity that seems dangerous. Instead, examine how many risks you genuinely want to accept. Then, considering buying the riskier product, consider how much of your portfolio should be put at those risk levels.
Based on data and facts, investing should consider how many risks you are willing to take to get your desired returns.
Analyzing the risk-return relationship, you can determine the likelihood of generating money on an investment or suffering a loss. This will enable you to make wise decisions.
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