📚 PASS Research Analyst Certification Examination Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 12.3 — Risks in Investments

Imagine you are presenting two equity research ideas to your investment committee. Stock A, a high-growth technology firm, delivered a 25% return last year, while Stock B, a stable FMCG giant, delivered a more modest 15%. A novice analyst might immediately recommend Stock A for its superior absolute return. However, as a professional, you recognize that looking at nominal returns in isolation is a rookie mistake that ignores the ‘price’ paid for that performance in terms of volatility.

Risk-adjusted return measures, such as the Sharpe Ratio, allow us to normalize performance by accounting for the volatility, or standard deviation, inherent in an asset. The logic is simple yet profound: an investment’s return is only impressive if it compensates the investor for the specific level of risk they were forced to endure.

By subtracting the risk-free rate—typically the yield on Indian Government Securities—from the portfolio return and dividing by the standard deviation, we derive a metric that tells us how much ’excess return’ we are earning per unit of total risk.

In the Indian context, consider two mutual funds with identical 12% returns. If Fund X achieved this with a high standard deviation due to aggressive mid-cap exposure, while Fund Y achieved it with lower volatility through a large-cap focused strategy, their risk-adjusted profiles differ vastly. Fund Y is technically the superior investment because it provided the same reward with less turbulence. In your research notes, calculating these ratios is crucial when comparing companies within the same industry that exhibit different beta profiles or operational leverage.

Integrating these metrics into your valuation models transforms your output from descriptive to prescriptive. When you evaluate a company’s historical performance or project future returns, always calculate the Sharpe or Treynor ratio to validate whether management’s capital allocation has truly created value. If a company shows high returns but possesses an abysmal risk-adjusted metric, it often signals that the ‘growth’ is actually a byproduct of excessive, uncompensated risk-taking. As an analyst, your duty is to identify companies that generate superior returns without exposing shareholders to unnecessary, non-linear downsides.

Nuance

⚠️ Nuance
A common pitfall is the belief that higher risk always equates to higher expected returns, leading candidates to ignore assets with lower volatility. In professional analysis, we seek to improve the efficiency of the risk-return frontier, not just maximize raw returns. Analysts often mistakenly equate high returns with management skill, failing to account for the possibility that the returns were merely compensation for taking on excessive systematic or idiosyncratic risk.

Check Your Understanding

Practice Question 1

An analyst evaluates two portfolios. Portfolio X has an annual return of 18% with a standard deviation of 12%. Portfolio Y has an annual return of 14% with a standard deviation of 8%. If the risk-free rate in India is 6%, which portfolio provides a better risk-adjusted return using the Sharpe Ratio?

Practice Question 2

In the context of the Treynor Ratio, which risk component is used to measure the ‘unit of risk’ instead of the standard deviation used in the Sharpe Ratio?

This is a companion read for Section 12.3 — Risks in Investments from PASS Research Analyst Certification Examination by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.