Risk management is a crucial process used to make investment decisions. The process involves identifying and analyzing the amount of risk involved in an investment, and either accepting that risk or mitigating it. Some common measures of risk include standard deviation, beta, value at risk (VaR), and conditional value at risk (CVaR).
- One of the principles of investing is the risk-return trade-off, where a greater degree of risk is supposed to be compensated by a higher expected return.
- Risk - or the probability of a loss - can be measured using statistical methods that are historical predictors of investment risk and volatility.
- Here, we look at some commonly used metrics, including standard deviation, value-at-risk (VaR), Beta, and more.
Standard deviation measures the dispersion of data from its expected value. The standard deviation is used in making an investment decision to measure the amount of historical volatility associated with an investment relative to its annual rate of return. It indicates how much the current return is deviating from its expected historical normal returns. For example, a stock that has high standard deviation experiences higher volatility, and therefore, a higher level of risk is associated with the stock.
For those interested only in potential losses while ignoring possible gains, the semi-deviation essentially only looks at the standard deviations to the downside.
The Sharpe ratio measures performance as adjusted by the associated risks. This is done by removing the rate of return on a risk-free investment, such as a U.S. Treasury Bond, from the experienced rate of return.
This is then divided by the associated investment’s standard deviation and serves as an indicator of whether an investment's return is due to wise investing or due to the assumption of excess risk.
A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to focus on the distribution of returns that are below the target or required return. The Sortino ratio also replaces the risk-free rate with the required return in the numerator of the formula, making the formula the return of the portfolio less the required return, divided by the distribution of returns below the target or required return.
Another variation of the Sharpe ratio is the Treynor Ratio that uses a portfolio’s beta or correlation the portfolio has with the rest of the market. Beta is a measure of an investment's volatility and risk as compared to the overall market. The goal of the Treynor ratio is to determine whether an investor is being compensated for taking additional risk above the inherent risk of the market. The Treynor ratio formula is the return of the portfolio less the risk-free rate, divided by the portfolio’s beta.
Beta is another common measure of risk. Beta measures the amount of systematic risk an individual security or an industrial sector has relative to the whole stock market. The market has a beta of 1, and it can be used to gauge the risk of a security. If a security's beta is equal to 1, the security's price moves in time step with the market. A security with a beta greater than 1 indicates that it is more volatile than the market.
Conversely, if a security's beta is less than 1, it indicates that the security is less volatile than the market. For example, suppose a security's beta is 1.5. In theory, the security is 50 percent more volatile than the market.
Value at Risk (VaR)
Value at Risk (VaR) is a statistical measure used to assess the level of risk associated with a portfolio or company. The VaR measures the maximum potential loss with a degree of confidence for a specified period. For example, suppose a portfolio of investments has a one-year 10 percent VaR of $5 million. Therefore, the portfolio has a 10 percent chance of losing more than $5 million over a one-year period.
Conditional Value at Risk (CVaR)
Conditional value at risk (CVaR) is another risk measure used to assess the tail risk of an investment. Used as an extension to the VaR, the CVaR assesses the likelihood, with a certain degree of confidence, that there will be a break in the VaR; it seeks to assess what happens to investment beyond its maximum loss threshold. This measure is more sensitive to events that happen in the tail end of a distribution—the tail risk. For example, suppose a risk manager believes the average loss on an investment is $10 million for the worst one percent of possible outcomes for a portfolio. Therefore, the CVaR, or expected shortfall, is $10 million for the one percent tail.
R-squared is a statistical measure that represents the percentage of a fund portfolio or a security's movements that can be explained by movements in a benchmark index. For fixed-income securities and bond funds, the benchmark is the U.S. Treasury Bill. The S&P 500 Index is the benchmark for equities and equity funds.
R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less typically does not perform like the index.
Mutual fund investors should avoid actively managed funds with high R-squared ratios, which are generally criticized by analysts as being "closet" index funds. In such cases, it makes little sense to pay higher fees for professional management when you can get the same or better results from an index fund.
Categories of Risks
Beyond the particular measures, risk management is divided into two broad categories: systematic and unsystematic risk.
Systematic risk is associated with the market. This risk affects the overall market of the security. It is unpredictable and undiversifiable; however, the risk can be mitigated through hedging. For example, political upheaval is a systematic risk that can affect multiple financial markets, such as the bond, stock, and currency markets. An investor can hedge against this sort of risk by buying put options in the market itself.
The second category of risk, unsystematic risk, is associated with a company or sector. It is also known as diversifiable risk and can be mitigated through asset diversification. This risk is only inherent to a specific stock or industry. If an investor buys an oil stock, he assumes the risk associated with both the oil industry and the company itself.
For example, suppose an investor is invested in an oil company, and he believes the falling price of oil affects the company. The investor may look to take the opposite side of, or hedge, his position by buying a put option on crude oil or on the company, or he may look to mitigate the risk through diversification by buying stock in retail or airline companies. He mitigates some of the risk if he takes these routes to protect his exposure to the oil industry. If he is not concerned with risk management, the company's stock and oil price could drop significantly, and he could lose his entire investment, severely impacting his portfolio.
The Bottom Line
Many investors tend to focus exclusively on investment returns with little concern for investment risk. The risk measures we have discussed can provide some balance to the risk-return equation. The good news for investors is that these indicators are calculated for them and are available on a number of financial websites: they are also incorporated into many investment research reports.
As useful as these measurements are when considering a stock, bond, or mutual fund investment, volatility risk is just one of the factors you should be considering that can affect the quality of an investment.