Hey teenagetraders!

When you're investing, one of the key things to keep in mind is how much risk you're taking for the return you expect. This brings us to Risk-Adjusted Return—a way to evaluate how much return you're getting relative to the amount of risk you're taking on.

What is Risk-Adjusted Return?

Risk-adjusted return measures how much return an investment provides compared to the level of risk involved. It’s like asking: "Am I getting enough bang for my buck in terms of risk?" A higher risk-adjusted return means you're getting more return for each unit of risk you take on, which makes an investment more attractive.

Key Metrics for Risk-Adjusted Return:

There are several methods for calculating risk-adjusted return, and each offers a different way to view the risk-return tradeoff:

1. Sharpe Ratio

The Sharpe Ratio is one of the most widely used measures of risk-adjusted return. It tells you how much return you're earning above a "risk-free rate" (often a U.S. Treasury bond) per unit of risk (measured by standard deviation).

• Formula:

• Example: Let's say Investment A has a return of 10%, and a standard deviation (risk measure) of 5%. If the risk-free rate is 2%, the Sharpe ratio would be:

• 10%−2%/5%=1.6

  A Sharpe ratio above 1 is considered decent, meaning you're getting a good amount of return for the risk you're taking.

2. Treynor Ratio

The Treynor Ratio is another measure, but instead of using total risk (standard deviation), it looks at systematic risk, or risk that affects the entire market, which is measured by beta.

• Formula:

3. Sortino Ratio

The Sortino Ratio is a modification of the Sharpe Ratio that focuses only on downside risk. This is great if you're more concerned about losses than overall volatility.

Why Does Risk-Adjusted Return Matter?

For young investors like you, risk-adjusted return is crucial because it helps you choose investments that provide the best returns for the level of risk you're comfortable taking. Two investments might both return 8%, but one could be much riskier. The risk-adjusted return helps you avoid taking on unnecessary risk for the same or lower returns.

Real-World Example

Imagine two investments, Stock A and Stock B:

• Stock A: 10% return with high volatility (Sharpe ratio of 1.0)

• Stock B: 8% return with low volatility (Sharpe ratio of 2.0)

Although Stock A has a higher return, Stock B has a much better risk-adjusted return, meaning it’s a more efficient use of your investment dollars for the level of risk.

Conclusion

Before jumping into high-return investments, always consider their risk-adjusted return. It can help you make smarter, long-term decisions. For our TCHS Wharton Investment Club members, these ratios will be crucial in determining what to invest in.

From your teenagetraders team!