Risk Adjusted return

Risk Adjusted return is a number which presents an investment’s return relative to its risk. The aim of an investor is to generate the maximum return with the minimum risk (volatility) possible. An investor will select investments with the highest risk adjusted return possible.

The most common risk adjusted metric is the Sharpe Ratio.

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Risk Adjusted Return Illustration

An investor has to choose between two investments with the equity curves displayed above. Although Investment 2 has a higher ending value than Investment 1, it has much higher volatility and drawdown than Investment 1. As a result, Investment’s 1 Sharpe Ratio is 3 times higher than Investment’s 2 Sharpe Ratio and hence Investment 1 is preferred.

Sharpe Ratio Example