What Is a Risk-Adjusted Return?
A risk-adjusted return measures how much an investment earned relative to the risk it took to earn it. Raw return tells only part of the story. Two investments might each gain 12% in a year, but if one swung sharply up and down while the other moved steadily, many investors would consider the steadier result more impressive. Risk-adjusted measures try to capture that difference in a single number.
These measures help compare assets with different risk profiles, such as a volatile growth fund and a conservative bond fund. Because risk can be defined in several ways, there is no single risk-adjusted return. Instead, there is a family of metrics, each built on a different idea of what risk means.
How It Is Measured
One widely used example is the Sharpe ratio. It compares the excess return above the risk-free rate with the investment's volatility. The formula is:
Sharpe ratio = (Investment return − Risk-free rate) ÷ Standard deviation of returns
The numerator is the return earned beyond what could be gained from a nearly risk-free asset, such as short-term government Treasury bills. The denominator is the standard deviation of returns, which measures how widely returns vary over time. A higher ratio indicates more return for each unit of volatility taken on.
Other measures use different risk inputs. The Sortino ratio counts only downside volatility, while measures based on beta compare returns with the investment's sensitivity to the broader market.
Example
Consider two hypothetical funds that each return 10% in a year, with a risk-free rate of 2%. Fund A has a standard deviation of 8%, and Fund B has a standard deviation of 16%. Fund A's Sharpe ratio is (10 − 2) ÷ 8 = 1.0, and Fund B's is (10 − 2) ÷ 16 = 0.5. Both earned the same raw return, but Fund A achieved it with less variability, so its risk-adjusted return is higher.
Why It Matters and Its Limits
Risk-adjusted measures help investors avoid judging performance by return alone. They are often used when comparing a mutual fund with its benchmark.
These measures have limitations. They rely on historical data, which may not predict future behavior. Different metrics can rank the same investments differently. Standard deviation treats upside and downside swings alike, and the choice of time period or risk-free rate can change the results. Used alongside other information, risk-adjusted measures can give a clearer picture of how an investment has performed.
Updated October 17, 2026. For general education only; not financial, tax or legal advice.