Risk-adjusted returns are a measure of investment performance that takes into account the amount of risk undertaken to generate a specific return. In other words, it evaluates the return of an investment relative to the level of risk associated with that particular investment.
The purpose of such is to enable fair comparisons between investments with different levels of risk. While many financial professionals are well acquainted with the concept, at Tegus, we’re here to provide a breadth of solid information and sometimes that means revisiting commonly-known industry terms. An example of a basic financial premise, understanding risk-adjusted returns is critical to holistically digesting risk positions within a fluctuating market.
Risk-adjusted returns offer a metric that can provide a more accurate picture of an investment's true performance and allows investors to assess whether the return they are receiving adequately compensates them for the level of risk they are taking on.
The formulas for calculating risk-adjusted returns vary depending on the specific metric used. Several of the most commonly used metrics include:
It's important to note that the calculations for other risk-adjusted return metrics, such as those listed here, are different and require different inputs and calculations. Ultimately, the best risk-adjusted return metric to use will depend on the specific investment, the analyst's goals and the available data. It's also important to keep in mind that risk-adjusted return metrics should be used in conjunction with other analysis tools and should not be used in isolation when evaluating an investment opportunity.
Risk-adjusted returns are a key consideration for private equity investors. Private equity investments typically involve buying a stake in a private company and working to improve its performance, with the goal of eventually selling the stake for a profit. Because private companies are typically less transparent and have less established track records than publicly traded companies, it's especially important for private equity investors to carefully consider the risk-adjusted returns of their investments.
One of the most commonly used metrics for evaluating private equity investments is the internal rate of return (IRR), which measures the annualized return that an investment generates over its lifespan, taking into account both the size and timing of the cash flows it generates. IRR is a widely used risk-adjusted return metric for private equity investments because it provides a comprehensive picture of the investment's risk-return profile and can be used to compare different investment opportunities.
However, IRR is not a perfect metric and has some limitations. For example, IRR assumes that all cash flows are reinvested at the IRR rate, which is often not the case in the real world. Additionally, IRR does not account for the risk associated with the investments, and therefore, other risk-adjusted return metrics, such as the Sharpe ratio or the Treynor ratio, may also be useful in evaluating private equity investments.
Ultimately, the choice of which risk-adjusted return metrics to use will depend on the specific goals and constraints of the private equity investor, as well as the characteristics of the investment opportunities being considered. As with any investment decision, it's important to carefully consider multiple risk-adjusted return metrics in conjunction with other investment metrics and market analysis to make a well-informed investment decision in private equity.
The definition of "good" risk-adjusted returns is dependent on an individual's investment goals and their own risk tolerance. Generally, a good risk-adjusted return is one that balances the level of risk taken with the return generated by an investment.
For some investors, a good risk-adjusted return might be a high return relative to the level of risk taken. For example, if an investor has a high tolerance for risk, they might be willing to accept a lower risk-adjusted return in exchange for the possibility of earning a higher return.
For other investors, a good risk-adjusted return might be a relatively low level of risk relative to the return generated. For example, if an investor has a low tolerance for risk, they might prioritize investments with a high risk-adjusted return even if the absolute return is lower.
In general, a good risk-adjusted return is one that aligns with an individual's investment goals and risk tolerance, and is consistent with their overall investment strategy. It's important to keep in mind that what constitutes a good risk-adjusted return will vary over time based on market conditions, economic indicators and other factors. At Tegus, we’re here to bring good information to the front, helping investors develop frameworks for better decisions at speed.