Common Methods of Measurement for Investment Risk Management

Risk management is a crucial process used to make investment decisions. Risk management involves identifying and analyzing risk in an investment and deciding whether or not to accept that risk given the expected returns for the investment. Some common measurements of risk include standard deviation, Sharpe ratio, beta, value at risk (VaR), conditional value at risk (CVaR), and R-squared.

Standard Deviation

Standard deviation measures the dispersion of data from its expected value. The standard deviation is commonly used to measure the historical volatility associated with an investment relative to its annual rate of return. It indicates how much of the current return is deviating from its expected historical normal returns. For example, a stock that has high standard deviation experiences higher volatility and is therefore considered riskier.

Standard deviation is most useful in conjunction with an investment's average return to evaluate the dispersion from historical results.

An alternative to the standard deviation is the semi-deviation, a measurement tool that only assesses part of an investment’s risk profile. The semi-deviation is calculated similarly to the standard deviation but can be used to specifically look at only the downside or risk of loss potential of an investment as only half the distribution curve is determined.

Sharpe Ratio

The Sharpe ratio measures investment performance by considering associated risks. To calculate the Sharpe ratio, the risk-free rate of return is removed from the overall expected return of an investment. The remaining return is then divided by the associated investment’s standard deviation. The result is a ratio that compares the return specific to an investment with the associated level of volatility an investor is required to assume for holding the investment. The Sharpe ratio serves as an indicator of whether an investment's return is worth the associated risk.

One 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 removes the risk-free rate of return in the numerator of the formula.

The Sharpe ratio is most useful when evaluating differing options. This measurement allows investors to easily understand which companies or industries generate higher returns for any given level of risk.

Another variation of the Sharpe ratio is the Treynor Ratio which integrates a portfolio’s beta with the rest of the market. Beta is a measure of an investment's volatility compared to the general market. The goal of the Treynor ratio is to determine whether an investor is being compensated fairly for taking additional risk above the market. The Treynor ratio formula is calculated by dividing the investment’s beta from the return of the portfolio less the risk-free rate.

Beta

Beta measures the amount of systematic risk an individual security or sector has relative to the entire stock market. The market is always the beta benchmark an investment is compared to, and the market always has a beta of one.

If a security's beta is equal to one, the security has exactly the same volatility profile as the broad market. A security with a beta greater than one means it is more volatile than the market. A security with a beta less than one means it is less volatile than the market.

Beta is most useful when comparing an investment against the broad market.

Beta can also be used to measure the scale of volatility that a security has compared to the market. For example, suppose a security's beta is 1.5. The security is considered 50% more volatile than the market. Beta is helpful when comparing across securities—at a glance, beta easily identifies that an investment with a beta of 1.5 is more volatile than an investment with a beta of 1.3.

Value at Risk (VaR)

Value at Risk (VaR) is a statistical measurement 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% VaR of $5 million. Therefore, the portfolio has a 10% chance of losing $5 million over a
one-year period.

There are several different methods for calculating Value at Risk, each of which with its own formula:

• The historical simulation method is the simplest as it takes prior market data over a defined period and applies those outcomes to the current state of an investment.
• The parametric method or variance-covariance method is more useful when dealing with larger data sets.
• The Monte Carlo method is best suited for the most complicated simulations and assumes the probability of risk for each risk factor is known.

Conditional Value at Risk (CVaR)

Conditional Value at Risk (CVaR) is another risk measurement 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 measurement is more sensitive to events that happen at the tail end of a distribution.

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 this one percent portion of the investment’s distribution curve. The VaR loss for this investment will likely be lower than $10 million as the CVaR loss often exceeds the distribution boundary of the VaR simulation.

R-squared

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 zero to one and are commonly stated as a percentage (0% to 100%). An R-squared value of 0.9 means 90% of the analysis accounts for 90% of the variation within the data. Risk models with higher R-squared values indicate that the independent variables being used within the model are explaining more of the variation of the dependent variable.

R-Squared is most useful when attempting to determine why the price of an investment changes. It's a byproduct of a financial model that clarifies what variables determine the outcome of other variables.

Mutual fund investors are often recommended to avoid actively managed funds with high R-squared ratios which are generally criticized by analysts as being "closet" index funds. In these cases, with each basket of investments acting very similar to each other, it makes little sense to pay higher fees for professional management when you can get the same or close results from an index fund.

Categories of Risks

Risk management is divided into two broad categories: systematic and unsystematic risk. Every investment is impacted by both types of risk, though the risk composition will vary across securities.

Systematic Risk

Systematic risk is associated with the overall market. This risk affects every security, and it is unpredictable and undiversifiable. However, systematic risk can be mitigated through hedging. For example, political upheaval is a systematic risk that can affect entire financial sectors such as the bond, stock, and currency markets. All securities within these sectors would be adversely impacted.

Unsystematic Risk

The second category of risk, unsystematic risk, is specifically 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, and every security has a different level of unsystematic risk. If an investor buys an oil stock, the investor assumes all risks associated specifically with the oil industry and the company itself.

To protect against unsystematic risk, 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 an unrelated company or industry. The ultimate goal is to reduce portfolio-wide exposure to the oil industry and the specific company.

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 automatically calculated and readily available on a number of financial websites. These metrics are also incorporated into many investment research reports.

When considering a stock, bond, or mutual fund investment, volatility risk and risk management are additional items to evaluate when considering the quality of an investment.