Why Returns Alone Aren't Enough
When evaluating investment performance, the headline return number only tells part of the story. Two investments might both return 15% annually, but if one achieved that return with significantly more volatility, these are not equivalent outcomes.
Key Concept
Risk-adjusted returns measure how much return you received for the amount of risk taken. Higher is better.
Consider this example: Fund A returned 12% with a standard deviation of 8%, while Fund B returned 15% with a standard deviation of 20%. Which performed better?
Intuitively, Fund A seems more attractive despite the lower absolute return—it delivered steadier performance with less dramatic drawdowns. Risk-adjusted metrics help us quantify this intuition.
Common Risk-Adjusted Metrics
Sharpe Ratio
The Sharpe Ratio is perhaps the most widely used risk-adjusted metric. It measures excess return (above the risk-free rate) per unit of total risk (standard deviation).
Formula:
Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation
Interpretation:
- Sharpe > 1.0: Good
- Sharpe > 2.0: Very good
- Sharpe > 3.0: Excellent (but verify the data)
Limitation
The Sharpe ratio treats upside and downside volatility equally. Some argue this penalizes strategies that have frequent positive surprises.
Sortino Ratio
The Sortino Ratio addresses the Sharpe ratio's limitation by only penalizing downside volatility. It uses downside deviation instead of total standard deviation.
Formula:
Sortino Ratio = (Portfolio Return - Target Return) / Downside Deviation
This metric is particularly relevant for investors who are primarily concerned with avoiding losses rather than avoiding volatility in general.
Maximum Drawdown
While not a ratio, maximum drawdown is a crucial risk metric. It measures the largest peak-to-trough decline in portfolio value.
A 50% drawdown requires a 100% gain to recover—understanding this asymmetry is essential for portfolio construction.
Practical Application
Building a Risk-Aware Portfolio
When we evaluate potential investments at DYORfunds, we always consider both absolute return potential and the risk required to achieve those returns. Here's our framework:
- Screen for minimum Sharpe threshold - Typically 0.5 or higher
- Evaluate maximum drawdown tolerance - What's the worst realistic outcome?
- Assess correlation - How does the investment behave relative to existing positions?
- Consider liquidity - Can we exit if our thesis changes?
Comparing Investment Options
| Investment | Annual Return | Std Dev | Sharpe | Max Drawdown | |------------|--------------|---------|--------|--------------| | Fund A | 10% | 8% | 0.88 | -12% | | Fund B | 14% | 18% | 0.61 | -35% | | Fund C | 12% | 10% | 0.90 | -18% |
Looking at this table, Fund C offers an attractive balance—competitive returns with moderate risk and drawdown. Fund B's higher absolute return comes with significantly more risk.
Beyond the Numbers
While quantitative metrics are valuable, they're backward-looking. Past risk-adjusted returns don't guarantee future performance. We also consider:
- Strategy consistency - Is the approach repeatable?
- Manager experience - How have they performed through market cycles?
- Structural advantages - Are there durable competitive moats?
Pro Tip
The best risk-adjusted returns often come from investments that others overlook or misunderstand. Patience and contrarian thinking can be significant advantages.
Conclusion
Risk-adjusted returns provide a more complete picture of investment performance than raw returns alone. By incorporating metrics like Sharpe ratio, Sortino ratio, and maximum drawdown into your analysis, you can make more informed decisions about where to deploy capital.
This content is for educational purposes only and does not constitute investment advice. All investments involve risk of loss. Consult a qualified financial advisor before making investment decisions.