What does the term "risk-adjusted return" measure?

The term "risk-adjusted return" specifically measures the performance of an investment while taking into account the level of risk taken to achieve those returns. This concept is crucial in evaluating how effectively an investment has compensated an investor for the amount of risk involved. Investors typically want not just high returns but returns that are reasonable given the investment's volatility and risk profile.

Considering risk-adjusted returns helps investors compare different investments on an equal footing. For instance, two investments might offer the same return, but one might involve significantly more risk. By adjusting for that risk, investors can make more informed decisions regarding which investments are more favorable. This is crucial for constructing a diversified portfolio that aligns with an individual's risk tolerance and investment goals.