M2 Risk Adjusted Return

Investment professionals deal in risk and return, which under modern finance theory are inextricably linked. An interpretational problem arises, however, from the fact that risk and return are usually expressed on different scales: return is expressed in percent per year, and risk is expressed as standard deviation from the mean return. It is desirable to have one number expressing risk adjusted return.

For the purpose of incorporating in a single number the concept of risk adjusted return, Nobel Laureate Franco Modigliani and his granddaughter constructed a statistic they called “M2.” M2 is expressed as the under performance in percent per year (a negative number) or the out performance in percent per year (a positive number) of a security in relation to a benchmark with the number being adjusted for relative risk.

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