Overview

Many basic financial performance measures, such as portfolio return, fail to account for risk. Using such measures tends to be misleading, in that some portfolios will achieve a high performance solely from taking excess risk. There have been multiple risk adjusted performance measures suggested in the financial literature.

Risk Adjusted Measures

The risk return trade off methodology starts by assuming that you have some measure of expected return (typically a measure of excess return over the risk free rate), and a measure of portfolio risk. Once these are calculated, one simply divides the return by the risk to get a risk adjusted return figure.

• Sharpe Ratio
  The mean variance approach to portfolio construction takes the expected return against the portfolio variance as risk. The risk adjusted return is then simply the Sharpe Ratio
  
  
  {% Sharpe \; Ratio = \frac{R_{port} - R_{risk free}}{\sigma} %}
• CAPM Ratio
  Within the context of the capital asset pricing model, the only risk that an investor is compensated for is systemic risk, measure by {% \beta %}. Therefore, the CAPM proposes a correction to the Sharpe ratio where the denominator is replaced by {% \beta %}
  {% CAPM \; Ratio = \frac{R_{port} - R_{risk free}}{\beta} %}
• Value at Risk Ratio
  {% VAR \; Ratio = \frac{R_{port} - R_{risk free}}{Value \; at \; Risk} %}