Being able to measure and quantify risk/return is a top priority when trying to evaluate investment portfolios. There are a lot of sophisticated tools that can help investors evaluate risk-adjusted portfolio performance. These tools are also useful to compare investment strategies, indices, or even the historical performance of different money managers and hedge funds.
Combining Risk and Return into a Single Comparable Value
There are two main investing goals: (i) get the highest annual payout (Return), by (ii) minimize the chances of losing money (Risk). By combing risk and return into a single value, investors can compare the real performance of different portfolios. This combination is called risk-adjusted portfolio performance. This analysis includes the following risk-adjusted portfolio performance ratios:
(1) Sharpe Ratio
(2) Sortino Ratio
(3) Treynor Measure or Traynor Ratio
(4) Jensen Measure or Jensen Alpha
(5) Calmar Ratio
(6) MAR Ratio
(7) Omega Ratio
(8) Information Ratio or Appraisal Ratio
(-) Key Points of the Analysis
Three Key Investment Concepts Before Moving On
Before moving on with the ratios that measure risk-adjusted performance, it is important to mention some basic concepts. These concepts include the risk-free rate of return, the standard deviation (SD), and the maximum drawdown. Most of the following performance ratios are partially based on these three important components.
(i) The Risk-Free Rate of Return
The risk-free rate refers to the annual return an investor can earn without taking any risk. Generally, the risk-free rate of return is based on the annualized interest paid on a 3-month Treasury bill. Any investment that is expected to offer lower returns than the risk-free rate of return is an unacceptable investment.
- You can use the annualized return of the 3-month US Treasury Bill in the US or the 3-month Euribor in the EU