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Risk adjusted performance is an evaluation of the manner in which an investment generates some sort of return in comparison to the amount of risk associated with that particular security. The idea of this type of adjustment is to help an investor determine if the asset is performing at a level that is acceptable given the amount of risk that the investor assumes in order to own that asset. This type of evaluation may be used to project future performance and aid the investor in deciding whether to purchase a new security for inclusion in the portfolio, or to trade a currently held asset that shows signs of increased risk that offset whatever gains could be made.
There is more than one way to go about determining the risk adjusted performance of an asset. One approach is to focus on the risk or volatility of the asset in the current market conditions, and decide if the growth or returns that are currently being generated are sufficient to merit assuming that risk. To an extent, this is a subjective approach to using this type of financial management tool, since only the investor can decide if the risk involved is worth the potential returns.
Another approach to risk adjusted performance involves looking beyond the performance of the asset itself and considering the overall performance of the market in which that asset is traded. For example, an investor may be considering the purchase of stocks issued by a retailer and decide to not only look at the performance of the stock within the market, but how that performance relates to the movement of the retail market overall. If the investor finds that the retail market appears to be stable and is likely to remain so for a reasonable period of time, there is a good chance that the risk will remain within acceptable limits in relation to the growth of the stock in question, making the trade worth further consideration.
As with any type of financial management techniques, assessing risk adjusted performance is helpful but not necessarily foolproof. Whatever method is used, there is the opportunity for incorrect information to lead to a projection that is not sound, which in turn means that there may be more risk involved that the investor perceives, or the projections of returns may be inflated and unrealistic. For this reason, assessing risk adjusted performance requires making sure all the data collected for the evaluation is factual and that the projections are a reasonable interpretation of those facts is crucial if the investor is to actually earn a decent return from the activity.