Risk-Adjusted Returns ⚖️🔍

Imagine two investors:

• Investor A: Makes a 15% return by investing in low-risk Government bonds and Blue-chip stocks.
• Investor B: Makes a 15% return by betting their entire life savings on a single, penny-stock startup.

Both made 15%. But who did "better"? In finance, Investor A is the winner because they achieved that return with much less risk. This is the logic of Risk-Adjusted Returns.

1. The Concept of Excess Return

Before we adjust for risk, we first look at Excess Return. This is the return you made over and above the "safe" money.

Excess Return = Portfolio Return (Rp) - Risk-Free Rate (Rf)

If you made 12% and Govt bonds gave 5%, your "Excess Return" for taking risk was 7%.

2. Why Adjustment is Mandatory

Judging a manager on absolute returns is dangerous because it encourages "Excessive Risk Taking."

• A manager might take massive risks to show a high return, knowing that if it fails, it's the client's money that is lost.
• Risk-adjustment "penalizes" returns that were achieved through high volatility or high market sensitivity (Beta).

3. The Big Three Ratios

To calculate risk-adjusted returns, economists use three primary ratios which we will cover in the next three chapters:

1. Sharpe Ratio: Adjusts for Total Risk (Standard Deviation).
2. Treynor Ratio: Adjusts for Systematic Risk (Beta).
3. Jensen's Alpha: Measures how much a manager "beat the market" after adjusting for their risk level.

Summary

• Absolute returns are misleading without risk context.
• Excess Return is the reward for taking any risk at all.
• Risk-adjustment ensures that managers are rewarded for skill, not just for being "lucky" with high-risk bets.
• It is the most important concept in professional portfolio management.

Quiz Time! 🎯

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