Measuring risk is an important part of evaluation in investing. There are hardly any risk-free asset classes, so knowing how to assess the inherent risk of an investment is key. Two common risk measurements in modern portfolio theory, or MPT, applied to both individual stock and mutual fund analysis are the Sharpe ratio and alpha. These statistical measures can show historical volatility, helping investors determine which stocks and funds fit well in line with their investment risk tolerance.
The Sharpe ratio is a risk-adjusted return measurement developed by economist William Sharpe. It is calculated by subtracting the risk-free return, defined as a U.S. Treasury Bond, from the investment's rate of return, and then dividing by the investment's standard deviation of returns. For investors, the Sharpe ratio illustrates how a mutual fund achieves its returns. It is useful in this way for comparing funds with similar historical returns. For example, if fund A and fund B both have 10-year returns of 5%, and fund A has a Sharpe ratio of 1.40 and fund B has a Sharpe ratio of 1.25, the conservative investor chooses fund A, as a higher Sharpe ratio indicates a higher risk-adjusted return.
Alpha also offers a way to measure returns on a risk-adjusted basis but applies the measure in relation to a benchmark to gauge performance. For investors seeking an investment that closely matches the performance of a chosen benchmark, alpha is the number to review. Alpha equal to 1.0 indicates the fund has beaten the benchmark by 1%, so the higher the alpha, the better. If the fund holds similar investments to the benchmark, a positive alpha indicates the fund manager's worth.