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. 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!
  2. Investing

    Find The Highest Returns With The Sharpe Ratio

    Learn how to follow the efficient frontier to increase your chances of successful investing.
  3. Investing

    PRHSX: Risk Statistics of Health Sciences Mutual Fund

    Examine the risk metric of the T. Rowe Price Health Sciences Fund. Analyze beta, capture ratios and standard deviation to assess volatility and systematic risk.
  4. Financial Advisor

    Measure Your Portfolio's Performance

    Learn three ratios that will help you evaluate your investment returns.
  5. Investing

    Quantitative Analysis Of Hedge Funds

    Hedge fund analysis requires more than just the metrics used to analyze mutual funds.
  6. Trading

    Bettering Your Portfolio With Alpha And Beta

    Increase your returns by creating the right balance of both these risk measures.
  7. Investing

    Beta: Gauging Price Fluctuations

    Learn how to properly use this measure that can help you meet your criteria for risk.
  8. Investing

    More Ways to Evaluate Portfolio Performance

    The Jensen measure is another tool investors use to include risk when measuring portfolio performance.
  9. Investing

    3 Ways To Evaluate the Performance of Alternatives

    Learn about three ways to measure the performance of alternative investments. See how the commonly used Sharpe ratio has drawbacks in measuring volatility.
  10. Investing

    What is a Security Market Line?

    The security market line graphs the systematic risk versus return of the whole market at a certain time, and shows all risky marketable securities.
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center