Risk-Adjusted Returns

Over the past several weeks I reviewed several measures of return, risk and correlation. These tools allow the intelligent investor to evaluate securities and determine how they will perform relative to each other inside a portfolio.

Many retail investors do not appreciate the relationship between the return of an investment and the risk of that investment. If we were to ask investors rather generally about their investments, many would be able to tell us how they have performed in terms of rate of return. However, if we were to ask how much risk they accepted to achieve those returns, few investors would know.

Investing involves balancing the risk and return of investments. You might think of the process this way. When you invest you enter the marketplace with a bucket of risk. The marketplace consists of all kinds of investments offering various amounts of return and requiring the acceptance of proportional amounts of risk. If you are willing to accept no risk, your only option is securities issued and guaranteed by the United States government. You will not lose your money. However, the return you receive will be very low.

If you are willing to accept a very large amount of risk, you might invest in highly speculative hedge funds or private equity. These investments can return 20%, 40%, 50% or more. However, you could also lose some or all of your money.

The point is that investors should be aware of how much risk they are accepting when they deposit their money in an investment. The most attractive investments are those that have relatively high risk-adjusted returns.

Given the choice between two investments with the same expected, which are otherwise similar, the rational investor will place money in the security with a lower level of risk. Alternatively, if two investments have similar levels of risk, the rational investor will select the investment with the higher expected return.

Of course the amount of money you receive from your investments will also be a function of how much money you are willing to part with. The more you are willing to invest, the more you are likely to receive.