What is the concept of risk-adjusted return, such as the Sharpe ratio?

• A. A measure of return earned per unit of risk, computed as (portfolio return - risk-free rate) / standard deviation of return
• B. A measure of total return without regard to risk
• C. The ratio of portfolio standard deviation to return
• D. The ratio of risk-free rate to portfolio return

Answer: (A)

Risk-adjusted return expresses how much return you get for each unit of risk you take, so you can compare investments that have different levels of volatility. The Sharpe ratio specifically looks at the extra return earned above the risk-free rate (the reward for taking on risk) and scales it by how volatile the returns are. It is calculated as the portfolio’s return minus the risk-free rate, divided by the standard deviation of the portfolio’s returns. This tells you how efficiently the portfolio converts risk into return: a higher value means more reward per unit of risk.

For example, if a portfolio returns 8%, the risk-free rate is 2%, and its returns vary with a standard deviation of 10%, the Sharpe ratio would be (8% − 2%) / 10% = 0.6. This indicates the portfolio offers 0.6 units of excess return per unit of risk.

The other ideas don’t capture this balance between reward and risk: focusing only on total return ignores risk; taking the ratio of risk (volatility) to return or the inverse of that doesn’t reflect how much extra return is earned for taking on risk, nor does it compare against a risk-free baseline.