How is risk-adjusted return used in investment performance evaluation?

How is risk-adjusted return used in investment performance evaluation?

Risk-adjusted return is a measure used in investment performance evaluation to assess the return on an investment relative to the level of risk taken. It takes into account the inherent risk associated with an investment and adjusts the return accordingly.

One commonly used measure of risk-adjusted return is the Sharpe ratio. The Sharpe ratio calculates the excess return of an investment (the return above the risk-free rate) divided by the standard deviation of the investment's returns. This ratio provides a measure of how much return an investor is receiving for each unit of risk taken.

By using risk-adjusted return, investors can compare the performance of different investments on an equal footing, considering both the return and the risk involved. This allows investors to make more informed decisions by evaluating the trade-off between risk and return.

For example, two investments may have the same return, but one may have a higher level of risk. By calculating the risk-adjusted return, investors can determine which investment provides a better return relative to the risk taken. This helps in identifying investments that offer higher returns for a given level of risk or lower risk for a given level of return.

Overall, risk-adjusted return is a valuable tool in investment performance evaluation as it provides a comprehensive assessment of an investment's performance, considering both the return and the risk involved.