The Financial Times Guide to Understanding Finance, 2nd Edition

10

Risk and return IV: Risk-adjusted returns

• Returns and good luck
• Returns and risk-taking
• An example
• Jensen’s alpha
• The Treynor index
• The Sharpe ratio
• The RAP
• The Sortino ratio
• Final thoughts
• The big picture

The financial press often publishes rankings of mutual funds, and many investors read them eagerly. In fact, many even use them to make investment decisions. The problem is, most of these rankings are flawed. More often than not, they focus on short-term past returns, which is problematic on at least two counts: They are not necessarily indicative of future returns and they do not explicitly account for risk. In this chapter we’ll discuss how to rank funds properly, and assets in general, on the basis of their long-term risk-adjusted ...