Portfolio Risks - 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, variance 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:

  • 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 this measure to help you meet your criteria for risk within the article Beta: Gauging Price Fluctuations.


     
  • 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.

Alpha = [(sum of y) - ((b)(sum of x))]÷n

Where:
n = number of observations (36 months)
b = beta of the fund
x = rate of return for the market
y = rate of return for the fund

An alpha of 1.0 means the fund outperformed the market 1%.

  • 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.

Sharpe Ratio = (total return - risk free rate of return)
σ

Look Out!
The reverse of "the larger the Sharpe ratio, the greater the return" also holds true. The "lower the Sharpe ratio, the lower the potential return". If a security\'s Sharpe ratio were equal to "0", there would be no reward for taking on the higher risk, and the investor would be better off simply holding Treasuries (whose return is equal to the risk-free return component of the equation).

Stock Risk Reduction Strategies


Related Articles
  1. Professionals

    Stock Risks

    NASAA Series 65: Section 16 Stock Risks. In this section types of risks, quantitative analysis and risk measures associated to stock markets.
  2. Professionals

    Concept of Risk vs. Reward

    FINRA Series 6: Section 9 Concept of Risk vs. Reward. In this section: Measuring Portfolio Risks, Risk Measures (Alpha, Beta, Sharpe Ratio), Asset Allocation, Risk Tolerance and Time Horizon.
  3. Mutual Funds & ETFs

    5 Ways To Measure Mutual Fund Risk

    These statistical measurements highlight how to mitigate risk and increase rewards.
  4. Professionals

    Rates of Return - Internal Rate of Return

    FINRA/NASAA Series 65 - Rates of Return - Internal Rate of Return. In this section Internal rate of return, real return, risk-adjusted return, beta and total return.
  5. Fundamental Analysis

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  6. Bonds & Fixed Income

    Find The Highest Returns With The Sharpe Ratio

    Learn how to follow the efficient frontier to increase your chances of successful investing.
  7. Professionals

    Risk and Return Measures

    Risk and Return Measures
  8. Investing

    Measure Your Portfolio's Performance

    Learn three ratios that will help you evaluate your investment returns.
  9. Fundamental Analysis

    Quantitative Analysis Of Hedge Funds

    Hedge fund analysis requires more than just the metrics used to analyze mutual funds.
  10. Term

    Evaluating Alpha and Beta

    Alpha and beta are risk ratios that investors use to calculate, compare and predict returns.
RELATED TERMS
  1. Sharpe Ratio

    The Sharpe Ratio is a measure for calculating risk-adjusted return, ...
  2. Risk-Adjusted Return

    A concept that refines an investment's return by measuring how ...
  3. Standard Deviation

    1. A measure of the dispersion of a set of data from its mean. ...
  4. Beta

    Beta is a measure of the volatility, or systematic risk, of a ...
  5. Volatility

    1. A statistical measure of the dispersion of returns for a given ...
  6. Portable Alpha

    A strategy in which portfolio managers separate alpha from beta ...
RELATED FAQS
  1. What metrics should I use to evaluate the risk return tradeoff for a mutual fund?

    Understand the key metrics used to analyze mutual funds and how investors can use each measurement to determine the risk-reward ... Read Answer >>
  2. How does beta measure a stock's market risk?

    Learn how beta is used to measure risk versus the stock market, and understand how it is calculated and used in the capital ... Read Answer >>
  3. How does my insurance company determine what premiums I have to pay for coverage?

    Learn about some of the quantitative finance measures that investors without a strong math background can use in analyzing ... Read Answer >>
  4. How can I use alpha in conjunction with the Sharpe Ratio?

    Take a deeper look at the differences between alpha and the Sharpe ratio, two mutual fund performance measures based on modern ... Read Answer >>
  5. What is the difference between the Sharpe ratio and alpha?

    Use alpha and the Sharpe ratio to evaluate mutual funds by comparing their risk-adjusted returns. Learn what modern portfolio ... Read Answer >>
  6. What's the difference between alpha and beta?

    Learn about alpha and beta, two very important technical risk ratios that investors use to evaluate relative performance, ... Read Answer >>
Hot Definitions
  1. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  2. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  3. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  4. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  5. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  6. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
Trading Center