What is risk-adjusted return and how could it help you calculate risk?

• Understand how risk-adjusted return is calculated and how it could help investors manage market volatility and improve long-term performance.
• Investors may make the mistake of focusing on return in its most basic form, without considering the risks they’re exposed to in order to achieve those returns.
• Weakness in stocks in recent months provides a good reminder of why risk-adjusted return is such an important tool for investors to use to stay on track to meet their long-term goals.

Risk-adjusted return is a critical element to successful long-term investing, and one often overlooked — or misunderstood — by newer investors. I view risk-adjusted returns as perhaps the most important, least understood part of investing; after all, the return potential of any investment should be viewed in the context of the risks it takes to achieve that return.

So, what is “risk-adjusted return”? 

Risk-adjusted return is a calculation of the return (or potential return) on an investment such as a stock or corporate bond when compared to cash or equivalents. Risk-adjusted returns are often presented as a ratio, with higher readings typically considered desirable and healthy.

The Sharpe ratio formula is one of the most-commonly cited measures of risk-adjusted return. Developed by Nobel laureate William Sharpe, the Sharpe ratio calculates the return (or expected return) of an investment in excess of a “risk-free” security. While no investment is 100% risk-free, short-term U.S. Treasury bills are often used as the proxy for risk-adjusted comparisons. You can find Sharpe’s formula and a hypothetical comparison of two investments here:

Sharpe Ratio = (Return - Risk Free Rate) / Volatility

The table below shows the returns and Sharpe Ratio of two hypothetical investments. You had to withstand twice as much volatility — the degree of variation in the price of a security over time — to achieve the same portfolio return for Investment B vs. Investment A, meaning Investment A was a better performer on a risk-adjusted basis.

I’m not suggesting investors need to start calculating Sharpe ratios or other sophisticated metrics for their portfolios. But I do believe it is important to understand the concept. Recent history explains why.

The past 12 months provide a good — albeit painful — reminder of why the importance of risk-adjusted return can’t be overstated. During bull markets, most investors focus on return in its most basic form, without taking into consideration the risks they’re exposed to in order to achieve said returns. Unfortunately for most, the risks aren’t evident until after it’s too late and the market turns sharply lower.

For example, when the so-called FAANG stocks (Facebook, Amazon, Alphabet, Netflix and Google) were outperforming the broad U.S. market, investors may not have been focused on how rising rates could hurt the appeal of those mega-cap growth names.

When U.S. rates were at or near zero, investors were willing to pay up for the FAANG’s expected long-term cashflows. But once the Federal Reserve started aggressively raising interest rates, investors became more focused on near-term cashflows...and valuations. From Dec. 31, 2021 to June 30, 2022, the average price-to-earnings ratio for the FAANG stocks dropped 38% as the Fed Funds Rate went from 0% to 1.5% over the same time period.¹

As a result, the once high-flying FAANG names fell 33% in the first half of 2022, with individual names such as Netflix and Meta Platforms down more than 50% each, versus a 20% decline for the S&P 500.

FAANG stocks vs. S&P 500: Once hot names underperform in first half of 2022

One way to think of risk-adjusted return is that it’s like the speed limit for your car. If your destination is 60 miles away, you can get there in just over one hour if you stick to the 55 MPH limit. Or you can get there faster if you’re willing to drive above the speed limit. The faster you go, the quicker you could arrive. However, going above the speed limit increases your risk of getting a ticket, having to swerve wildly to avoid accidents, or something worse. And the faster you go the higher the odds of a bad outcome. 

The same is true of your investing. Building a diversified portfolio based on one’s risk tolerance and investment goals may feel like a slow (even boring) approach that means it could take longer to reach your destination (investing goals). But you most likely increase the odds of getting there. Focusing on hot trends may seem like a faster route to your goals and it may even be so for a time, but you also increase the risk of a financial ‘accident’. 

Considering the risks — and the risk-adjusted return — of your portfolio will go a long way to helping you stay on track, and on schedule while pursuing success in your investing journey.