Evaluating an investment by its nominal return is never enough. It’s important to examine how much risk is associated with that level of return - commonly referred to as "risk-adjusted returns." You always want to ensure that an investment is maximizing the amount of return it generates for the degree of risk it assumes.
Consider two stock mutual funds that averaged a 10% average annual return over the past 10 years. You might assume both managers did an equally good job of generating returns. But if you look at the breakout of annual returns, you might find that one fund experienced wide swings, up big in bull markets and massively down when the stock market declined. The other fund was much less volatile. It made modest gains in up markets and provided downside protection by not experiencing the full drop in market downturns.
That context suggests the managers of the second fund did a better job of generating returns for the amount of risk they assumed.
Sharpe ratio is a good measure of risk-adjusted returns
In the 1960s, the economist William Sharpe established a formula – known as the Sharpe ratio -- to determine how much return an investment generates for each unit of risk it assumes. As indicated below, the Sharpe ratio is calculated by looking at the additional return an investment delivered above the return of a risk-free investment like a Treasury note. The average excess return over a set period is then divided by how dispersed returns were, as measured by their standard deviation.
Sharpe ratio = (Return of an investment – The risk-free rate) / Standard deviation of the excess return
The higher the Sharpe ratio, the better an investment has historically done at delivering returns for the level of risk it assumes. In essence, the Sharpe ratio provides a good indication of an investment manager’s skill at managing risk.
Why an investment’s volatility matters
It’s important to consider the volatility of an investment. If you’re in retirement, for example, and drawing a percentage of your retirement savings to supplement your income, a major drop in the value of your investment would severely reduce the amount you could withdraw that year.
Even if you have time on your side because your investment goal is many years year away, volatility can have a negative impact. As the behavioral scientists have noted, it’s a natural human instinct to have loss aversion. We experience the pain of a loss to a much greater degree than we do than the joy of a gain.
That loss aversion can lead investors to panic selling during a market decline. People often go back into the market once it recovers, but they often do so too late and miss the most dramatic portion of the rebound. In the end, all they do with the panic selling is lock in their losses.
Finding less volatile investments – that is, those with higher Sharpe ratios – can help investors avoid these mistakes and stick with their financial plan for the long term.
Always take a closer look at returns
The first step in evaluating an investment is always to look at the return it has delivered. But the nominal return provides only a limited picture. Taking into account an investment’s risk-adjusted returns, with tools such as the Sharpe ratio, provides a fuller picture of how an investment has historically performed.