How does Morningstar calculate risk-adjusted returns?

The formula assumes investors are willing to forego part of the return for reduced volatility.

Morningstar Canada 16 October, 2017 | 5:00PM
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Question: I often see references to "risk-adjusted returns" on Morningstar.ca. What does this mean?

Answer: Think of risk-adjusted returns as a way to level the playing field by taking into account the volatility of a fund's performance. They help investors compare funds that take on lots of risk -- and therefore may experience outsized gains or losses -- with funds that take on less risk and have more stable returns, while acknowledging that investors tend to prefer the latter.

Most investors focus primarily on a fund's total return over a given period, but how the fund delivers those returns matters as well. Say that two funds both returned 20% last year, but one took a relatively smooth path while the other took investors on a roller coaster ride. For most investors, the smoother performance is preferable because a fund that is less volatile is easier to own than one that is more volatile. After all, a fund that experiences steep gains and steep losses is more likely to see investors bail out when the going gets rough -- possibly locking in losses in the process and, thus, missing out on any rebound that might occur. And even if investors in a volatile fund don't sell out at the worst possible time, they might still endure some sleepless nights.

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