Risk-adjusted return, in plain words

Return alone is half the picture

A fund's return tells you where it ended up. The path it took to get there is a separate question. A fund that fell hard and recovered can post the same yearly return as one that climbed steadily. Few investors would call those the same experience, and the rough one is the fund people sell at the bottom.

Measuring the ride

The usual measure of roughness is volatility, most often the standard deviation of returns: how far returns tend to swing around their average. A higher standard deviation means wider swings, up and down. It is usually calculated from monthly returns and stated as a yearly figure.

The Sharpe ratio

Risk-adjusted return puts the two together. The best-known measure is the Sharpe ratio: the fund's return minus the risk-free rate, divided by the fund's standard deviation.

The risk-free rate is what you could earn with almost no risk, usually taken from short-term Treasury bills. Subtracting it leaves the return you were paid for taking risk. Dividing by volatility turns that into return per unit of swing. Higher is better.

Hypothetical numbers, worked through

Fund P and fund Q are hypothetical. Both returned 8% a year over the same period. Assume a risk-free rate of 3% over that period.

Fund P had a standard deviation of 10%. Its Sharpe ratio is 8% minus 3%, divided by 10%: 0.5. Fund Q had a standard deviation of 20%. Its Sharpe ratio is the same 5% divided by 20%: 0.25. Same return. Fund P earned it with half the swing, so it earned twice as much for each unit of risk.

Reading a Sharpe ratio

A Sharpe ratio means something only in comparison. On its own, 0.5 is neither good nor bad. It tells you something when set beside funds that do the same job, measured over the same period. Watch the period: a ratio taken over calm years and one taken over a period with a sharp fall are not comparable. And when a fund returns less than the risk-free rate, the ratio drops below zero, where rankings can mislead.

Other measures you will see

The Sortino ratio works like the Sharpe ratio but counts only the downside swings, on the view that nobody minds a sudden rise. Maximum drawdown is the largest fall from a peak to a low before a new peak. Beta measures how much a fund tends to move with its market. Each answers a slightly different question about the same ride.

What it cannot tell you

Every one of these is measured on the past. A fund that was smooth for five years can be rough in the sixth. Standard deviation treats a rare large fall as one more swing, so it can understate the risk of a crash. And comparisons only hold between funds measured over the same period, against the same risk-free rate.

Use risk-adjusted return to compare funds that do the same job. Do not use it to predict next year.

How IQ Dragon uses it

Risk-adjusted returns is one of the five dimensions of the Dragon Score, weighted 25%, the same weight as historical performance. The score gives the ride as much say as the destination.