Measuring Portfolio Risks
One of the concepts used in risk and return calculations is standard deviation which measures the dispersion of actual returns around the expected return of an investment. Since standard deviation is the square root of the variance, this is another crucial concept to know. The variance is calculated by weighting each possible dispersion by its relative probability (take the difference between the actual return and the expected return, then square the number).

The standard deviation of an investment's expected return is considered a basic measure of risk. If two potential investments had the same expected return, the one with the lower standard deviation would be considered to have less potential risk.


Risk Measures
There are three other risk measures used to predict volatility and return:

  • Alpha - this measures stock price volatility based on the specific characteristics of the particular security. As with beta, the higher the number, the higher the risk.

  • Sharpe ratio- this is a more complex measure that uses the standard deviation of a stock or portfolio to measure volatility. This calculation measures the incremental reward of assuming incremental risk. The larger the Sharpe ratio, the greater the potential return. The formula is: Sharpe Ratio = (total return minus the risk-free rate of return) divided by the standard deviation of the portfolio.

  • Beta - this measures stock price volatility based solely on general market movements. Typically, the market as a whole is assigned a beta of 1.0. So, a stock or a portfolio with a beta higher than 1.0 is predicted to have a higher risk and, potentially, a higher return than the market. Conversely, if a stock (or fund) had a beta of .85, this would indicate that if the market increased by 10%, this stock (or fund) would likely return only 8.5%. However, if the market dropped 10%, this stock would likely drop only 8.5%.

  • Learn how to properly use beta to help meet your portfolio's risk criteria in the article, Beta: Gauging Price Fluctuations.

Asset Allocation
In simple terms, asset allocation refers to the balance between growth-oriented and income-oriented investments in a portfolio. This allows the investor to take advantage of the risk/reward tradeoff and benefit from both growth and income. Here are the basic steps to asset allocation:

  1. Choosing which asset classes to include (stocks, bonds, money market, real estate, precious metals, etc.)
  2. Selecting the ideal percentage (the target) to allocate to each asset class
  3. Identifying an acceptable range within that target
  4. Diversifying within each asset class

If you are unfamiliar with asset allocation, refer to the tutorial: Asset Allocation.

Risk Tolerance
The client's risk tolerance is the single most important factor in choosing an asset allocation. At times, there may be a distinct difference between the risk tolerance of a client and his/her spouse, so care must be taken to get agreement on how to proceed. Also, risk tolerance may change over time, so it's important to revisit the topic periodically.

Time Horizon
Clearly, the time horizon for each of the client's goals will affect the asset allocation mix. Take the example of a client with a very aggressive risk tolerance. The recommended allocation to stocks will be much higher for the client's retirement portfolio than for the money being set aside for the college fund of the client's 13-year-old child.

Strategic vs. Tactical Asset Allocation

Related Articles
  1. Investing

    5 Ways To Measure Mutual Fund Risk

    These statistical measurements highlight how to mitigate risk and increase rewards.
  2. Investing

    How to Use a Benchmark to Evaluate a Portfolio

    What is an investment benchmark and how is it used to evaluate the risk and return in a portfolio.
  3. Investing

    Understanding Volatility Measurements

    How do you choose a fund with an optimal risk-reward combination? We teach you about standard deviation, beta and more!
  4. Investing

    Why Standard Deviation Should Matter to Investors

    Think of standard deviation as a thermometer for risk, or better yet, anxiety.
  5. Investing

    How AQR Places Bets Against Beta

    Learn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices.
  6. Investing

    Evaluating Alpha and Beta

    Alpha and beta are risk ratios that investors use to calculate, compare and predict returns.
  7. Investing

    How To Measure Your Portfolio’s Performance

    The first tool for assessing portfolio performance while considering risk was the Treynor measure.
  8. Investing

    Understanding Beta

    Beta is a measure of volatility. Find out what this means and how it affects your portfolio.
  9. Financial Advisor

    Calculating Beta: Portfolio Math For The Average Investor

    Beta is a useful tool for calculating risk, but the formulas provided online aren't specific to you. Learn how to make your own.
  10. Trading

    Bettering Your Portfolio With Alpha And Beta

    Increase your returns by creating the right balance of both these risk measures.
Frequently Asked Questions
  1. How did the ABX index behave during the 2008 subprime mortgage crisis?

    Read about the disastrous performance of the various ABX indexes in the subprime mortgage crisis of 2008 during the middle ...
  2. How did moral hazard contribute to the 2008 financial crisis?

    Learn about moral hazard, how it can affect outcomes and how it contributed to the conditions that led to the 2008 financial ...
  3. Which mutual funds made money in 2008?

    Read about the only mutual fund that turned a profit in 2008. Learn about risk-averse investment strategies and the financial ...
  4. Were Collateralized Debt Obligations (CDO) Responsible for the 2008 Financial Crisis?

    Collateralized debt obligations are exotic financial instruments that can be difficult to understand, Learn the role they ...
Trading Center