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Tutorial |
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| Risk-adjusted
Return |
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| Goal |
To illustrate the usefulness of knowing an investment's Risk-Adjusted Return,
which is commonly measured by the Sharpe Ratio.
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| Definition |
- Risk-Adjusted Return: The return on an asset or a portfolio, adjusted for
volatility; commonly represented by the Sharpe Ratio.
- Sharpe
Ratio:
A ratio of return to volatility; useful in comparing assets or portfolios in terms
of risk-adjusted return.
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| How it works |
The historical average return of
an asset or portfolio can be extremely misleading, and should not be considered
alone when selecting assets or comparing the performance of portfolios.
The Sharpe Ratio is such an important tool because it allows you to factor in
the potential impact of Return Volatility on Expected Return, and to objectively
compare assets or portfolios that may vary widely in terms of returns.
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| A Practical
Example |
Consider Assets A, B and C in the chart
below:
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Avg. Annual
Return |
Return Volatility |
Sharpe Ratio |
| Asset A |
54.52% |
177.20% |
0.279 |
| Asset B |
36.91% |
68.20% |
0.468 |
| Asset C |
25.64% |
22.69% |
0.910 |
If we compare these assets on average annual return alone, Asset A appears to
be the clearly superior investment, and even Asset B appears to be a better bet
than Asset C. However, if we factor in return volatility, Asset C emerges
as the superior investment in terms of risk-adjusted
returns.
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| Conclusion |
When selecting assets for inclusion in a portfolio,
or when comparing the performance of two portfolios, it is important to look
beyond average historical return. Risk-adjusted return, as measured by the
Sharpe Ratio, provides a useful, reliable means of factoring Return Volatility
into your assessment.
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| Relevant
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