These risk measurements are intended to help investors determine the risk-reward parameters of their investments.
9th August 2013
There are five main indicators of investment risk that apply to the analysis of bonds, stocks and mutual fund portfolios, Alpha, Beta, R-Squared, Standard Deviation and the Sharpe Ratio. These statistical measures are historical predictors of investment/risk and major components of modern portfolio theory (MPT). The MPT is a standard financial and academic methodology used for assessing the performance of equity, fixed income and mutual fund investments by comparing them to market benchmarks. These risk measurements are intended to help investors determine the risk-reward parameters of their investments.
It is a measure of an investment’s performance on a risk adjusted basis. It takes the volatility of a security or bond portfolio and compares its risk adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its Alpha. It is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio’s return. A positive Alpha of 1 percent means the fund has outperformed its index by 1 percent. Correspondingly, a negative alpha would indicate an underperformance of 1 percent. It would be beneficial for the investor if the Alpha is positive, as it gives more returns on his investment.
It is also known as the beta coefficient and a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. It is calculated using regression analysis and it is the tendency of an investment’s return to respond to swings in the market. By market terms, the Beta has one individual and security portfolio values and measured according to how they deviate from the market. A beta of 1.0 indicates that the investment’s price will move in lock step with the market, a value of less than 1.0 indicates the investment will be less volatile than the market and likewise a beta of more than 1.0 indicates the investment’s price will be more volatile than the market. For example, if a fund’s portfolio beta is 1.2, it’s theoretically 20 percent more volatile than the market. Investors willing to take more risk in search of higher returns should look for high beta investments.
This is a statistical measure representing the percentage of a fund portfolio’s or security’s movements that can be explained in a benchmark index. For fixed income securities and their corresponding mutual funds, the benchmark is the U.S. Treasury Bill and likewise with equity funds the benchmark is S&P 500. The values of R-Square range from 0 to 100.
It measures the dispersion of data from its mean. Standard deviation is applied to the average rate of return (ARR) of an investment to measure its volatility. A volatile stock would have a high standard deviation. Standard Deviation on mutual fund tells us how much the return on a fund is deviating from the expected returns based on its historical performance.
The ratio developed by Nobel laureate William Sharp, measures risk adjusted performance. It is calculated by subtracting the risk free rate of return from the rate of return from an investment and dividing the result by the investment’s standard deviation of its return. It tells investors whether an investment’s returns are due to smart investment decisions or due to excessive risks. This assessment is extremely useful to the investors because even if a security or portfolio can reap higher returns than its peers, it is only a good investment if those higher returns do not come up with additional risk.
These tools are extremely useful to the investors as they tend to focus exclusively on investment return, with little concern for investment risk. These financial parameters to gauge risk and investment returns are available on most of the websites as well as into many investment research reports.