What is a risk-adjusted return?

A risk-adjusted return is a financial metric that evaluates the return of an investment while taking into account the level of risk associated with that investment. This concept is crucial because it allows investors to understand how much return they are earning for the level of risk they are exposing themselves to.

By incorporating risk into the assessment, investors can make more informed decisions by comparing the effective returns of different investments that may have varying risk profiles. For example, an investment that yields a high return might not be appealing if it also comes with a high level of risk, while a more stable investment with lower returns might be considered more favorable.

This measure typically involves using statistical techniques to normalize returns for risk, such as the Sharpe ratio, which considers excess return per unit of risk. Understanding risk-adjusted returns helps investors to gauge whether they are being adequately compensated for the risks they are taking within their portfolios.