What is risk-adjusted return and how do I measure it in today's market?
In the context of Modern Portfolio Theory, risk-return relation is the theoretical
association between the return expected from investment and the amount of risk
assumed in that investment. The more return investor expects from the market,
the more risk must be undertaken to achieve that return.
Before comparing or considering investments, it is better to perform a risk-adjusted return calculation
that will adjust the returns according to how risky the investments are.
The riskier they are, the more the returns are lowered before any comparison.
Technically risk refers to mean volatility, which measures how returns vary over a given period of time.
An investment or a portfolio that grows steadily has low risk, and another investment with
a value that jumps up and down unpredictably has high risk.
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How to diversify based on risk adjusted returns
The concept of diversification is tightly coupled with the notion of correlation between securities that make up portfolio.
The correlation coefficient is a statistical measurement between negative one and positive one that
measures the degree to which the various assets in a portfolio can be expected to perform in a
similar fashion or not. A measure of -1 means that the assets within the portfolio perform perfectly
oppositely: whenever one asset goes up, the other goes down.
A measure of 0 means that the assets fluctuate independently, i.e. that the performance of one asset
cannot be used to predict the performance of the others. A measure of 1, on the other hand,
means that whenever one asset goes up, so do the others in the portfolio.
To eliminate diversifiable risk completely, one needs an intra-portfolio correlation of -1,
although in reality, perfectly correlated securities are very rare.
Today, most investors and professional money managers use Sharpe Ratio to measure risk-adjusted returns.
The Sharpe Ratio is defined as reward-to-variability ratio and is a measure of the excess return
(or Risk Premium) per unit of risk in an investment asset or a trading strategy.
The Sharpe Ratio is used to characterize how well the return of an asset compensates
the investor for the risk taken. When comparing two assets with similar expected returns against the same benchmark,
the asset with the higher Sharpe Ratio gives more return for the same risk.
Investors are often advised to pick investments with high Sharpe Ratios.
Please, click here to view life correlation matrix
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References
Modern Portfolio Theory From Wikipedia, the free encyclopedia Learn About Modern Portfolio Theory (MPT)
Markowitz, Harry M. (1952). Portfolio Selection, Journal of Finance, 7 (1)
Sharpe, William F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk, Journal of Finance, 19(3)
Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets, The Review of Economics and Statistics, 47 (1), 13-39
Burmeister E and Wall KD., The arbitrage pricing theory and macroeconomic factor measures, The Financial Review, 21:1-20, 1986
Chen, N.F, and Ingersoll, E., Exact pricing in linear factor models with finitely many assets: A note, Journal of Finance June 1983
Fama, E. and French, K. (1992). The Cross-Section of Expected Stock Returns, Journal of Finance, June 1992, 427-466
Black, F., Jensen, M., and Scholes, M. The Capital Asset Pricing Model: Some Empirical Tests, in M. Jensen ed., Studies in the Theory of Capital Markets. (1972)
French, C. W. (2003). "The Treynor Capital Asset Pricing Model", Journal of Investment Management, 1 (2), 60-72
Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets, Review of Economics and Statistics, 47 (1), 13-37
Markowitz, Harry M. (1999). The early history of portfolio theory: 1600-1960, Financial Analysts Journal, 55 (4)
Tobin, James (1958). Liquidity preference as behavior towards risk, The Review of Economic Studies, 25
Treynor, J. L. (1961). "Market Value, Time, and Risk." Unpublished manuscript.
Treynor, J. L. (1962). "Toward a Theory of Market Value of Risky Assets." Unpublished manuscript.
Other Resources
Robust Portfolio Optimization and Management by Frank J. Fabozzi, Petter N. Kolm, Dessislava Pachamanova, Sergio M. Focardi
Portfolio Optimization and Performance Analysis by Jean-Luc Prigent
Option Pricing and Portfolio Optimization by Ralf Korn, Elke Korn
Portfolio optimizations in incomplete financial markets by Walter Schachermayer
Bond Portfolio Optimization by Michael Puhle
An MCDM approach to portfolio optimization by M. Ehrgott, K. Klamroth, C. Schwehm
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Efficient Frontier  15511 global portfolios
1 |  | Slick | 65 | 2 | | fullo | 52 | 3 | | Tobby23748 | 41 | 4 | | Camden18579 | 38 | 5 | | MyBhavesh | 38 |
1 |  | AAPL | 226 | 2 | | GOOG | 220 | 3 | | GE | 192 | 4 | | MSFT | 148 | 5 | | C | 134 |
1 | | SPY | 123 | 2 | | EEM | 119 | 3 | | GLD | 110 | 4 | | EFA | 103 | 5 | | VWO | 96 |
1 | | VFINX | 59 | 2 | | FCNTX | 58 | 3 | | VTSMX | 54 | 4 | | DODFX | 53 | 5 | | VBMFX | 52 |
1 | Shepherd Kaplan | 5 | 2 | Hilltop Advisor | 5 | 3 | Babson Capital | 3 | 4 | Eldridge Financ | 3 | 5 | Vest Assured I | 3 |
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