While high returns are often the focus of finance, more savvy investors understand that managing Risk effectively can make the difference between long-term successes and catastrophic losses. It’s not about avoiding all risks but rather about understanding and minimizing them.

Below, we will explore the most effective and common methods of measuring investment risk. We will review traditional metrics such as standard deviation and beta as well as sophisticated techniques like value at Risk (VaR), stress testing, and more.

Key Takeaways

• Risk management is the process of analyzing an investment’s return in relation to its level of Risk. Higher-risk investments are expected to have higher returns.
• Risk is measured using statistical methods that are based on historical data.
• Standard deviation, Sharpe ratio and beta are all common risk management techniques.
• Value at Risk (VaR) and other metrics quantify the potential dollar impact and assess the likelihood of specific outcomes.
• Risk management is concerned with both systematic (which affects all investments) and unsystematic (which only concerns individual investments).

Overview of Measuring Risk

Investors and financial professionals utilize a variety of tools to assess investment risk. The methods used range from simple statistical measures to complex mathematical models. Standard deviation and beta are the most basic risk measures that give you an idea of how volatile an investment is and compare it with the market. The more sophisticated techniques, such as VaR and Conditional VaR (CVaR), offer a subtler perspective on Risk.

Each method has strengths, and skilled risk managers combine them to create a more comprehensive risk profile. Predicting the weather based on temperature alone is like predicting the weather. Here is a list of key metrics for market assets.

1. Standard Deviation

The standard deviation is a popular statistical measure, second only to the mean. It quantifies the spread of data away from the mean. It is a kind of financial seismograph that measures the tremors within an investment, helping to predict earthquakes.

It’s often used in finance to measure an asset’s historical volatility relative to its rate of return. A stock with a large standard deviation will have a higher level of volatility and, therefore, be more risky.

The standard deviation is best used in conjunction with the average return on investment to determine the dispersion of historical results.

Important

The standard deviation can be calculated by multiplying the square root (S(x-m)2) by the number of items in the dataset: [S(x-m)2 /N], where x is each value of the dataset, m is the mean, and N is the number of data points.

Semi-deviation is an alternative to standard deviation, which only considers returns below the average. This is useful for investors who are more concerned with potential losses rather than overall volatility.

2. Sharpe Ratio

Sharpe ratio allows investors to determine how much extra return they receive for the additional volatility that comes with holding an asset. A higher Sharpe ratio indicates better risk-adjusted performance. A Sharpe ratio is usually considered to be good if it is 1.5, very good if it is 2.0, and excellent if it’s 3.0. These numbers are relative to the sector or market you are assessing.

The Sharpe ratio is widely used but has limitations. The Sharpe ratio assumes that returns are normally distributed, and it treats both upside and downside volatility as the same. In order to address these issues, a variety of variations has been developed:

• The Sortino ratio only focuses on the downside deviation. This is in contrast to the Sharpe ratio, which treats both upside and downside volatility equally.
• Treynor uses beta rather than standard deviation to evaluate diversified portfolios.

Important

Divide this result by the standard deviation of the investment’s excess return: (Rp – Rf) / sp where Rp = return of the portfolio, Rf = Risk-free rate and sp = standard deviation for an investment. Divide this result by the standard deviation for the excess return on the investment: (Rp – Rf)/sp, where Rp is the return of the Portfolio, Rf is the Risk-free Rate, and sp represents the standard deviation for the excess return.

3. The Beta

The beta value measures risk—the systematic Risk of a sector or security in relation to the overall stock market. Investors can quickly assess an investment’s volatility compared to a benchmark, usually the entire stock market.

If the beta of a security is equal to one, it has the same level of volatility as the market. A security that has a beta higher than one will be more volatile than the broad market. A security that has a beta of less than one will be less volatile than the market.

Important

The beta is calculated as follows: Covariance (ri, rm)/Variance(rm), where ri and rm are the returns on an investment.

4. Value at Risk (VaR)

Value at Risk is a statistical measure that measures the loss of value that could occur in an asset or portfolio over some time and for a confidence interval. It is a simple number that summarizes the Risk associated with an investment.

VaR is a forecast of the weather in terms of finance. It tells you what storms are likely to come. For example, let’s say a portfolio has a VaR of $10 million over a year. The portfolio, therefore, has a 10% risk of losing $5,000,000 over a year.

There are some limitations to the VaR.

• The software does not provide any information on the severity of the losses above the VaR threshold. You’ll get a forecast of the most likely storms but not the possibility that a low-percentage one could be devastating.
• YouRisk underestimates Risk in periods of market stress or when assets have abnormal return distributions.
• The same portfolio can have different results based on the calculation method used.

Tip

VaR is useful for assessing a specific outcome as well as the probability of it occurring.

VaR can also be calculated by using other methods.

• The historical methods use previous data to predict future outcomes.
• The variance and covariance method (or parametric method) assumes that returns are distributed normally.
• Monte Carlo Simulations Generate many scenarios using the criteria provided. 2

CoRiskional Value at Risk (CVaR).

CVaR, also known as expected shortfall or collisional value at Risk (CVaR), addresses some of Var’s limitations by measuring the expected losses should the loss exceed the VaR. CVaR is the equivalent of a weather forecast that tells how bad a storm will be.

Tip

Cvar will be most useful to investors who want to know the maximum possible losses for outcomes that are statistically unlikely to occur.

As an example, suppose that a risk manager determines that the average loss for an investment is $10,000,000 for the worst 1% possible outcomes in a portfolio. The CVaR, or expected shortfall, in this case, is $10 million. It is unlikely, but still possible. You should still plan for it.

5. R-Squared

The R-squared, also known as the coefficient of determination or the R 2, is the percentage of changes in an index that can explain the movements of a security or fund. The benchmark for equities is usually the S&P500, while U.S. Treasury Bills are used to calculate the coefficient of determination.

To use another analogy, the R 2 test is similar to financial DNA. It shows how much an investment’s behaviour is inherited by its benchmark. R-squared can be used for many purposes.

• How closely a mutual or exchange-traded fund (ETF) tracks its benchmark
• How to determine the relevance of alpha and beta metrics
• Identification of “closed index funds” that charge management fees but closely track an index.

If the R 2 is high (above 0.85), it could mean that the fund performs closely to its benchmark. This could be due to “closed indexing” in active funds or effective index tracking.

If the R-squared is low, it indicates that the fund’s performance is not driven by the movements of the benchmark.

Important

Divide the variance unexplained (the sum squared of residuals) by the variance total (the sum squared of squares). Subtract this quotient (R 2) from 1: 1 – (Sum Squared Residuals/Total Sum of Squares).

This metric has some limitations:

• The investment’s performance is not indicated.
• R-squared is not a guarantee that a fund will be a good investment. This means that it has a high correlation with the benchmark.
• R-squared may change over time, particularly during volatile market periods.

R-squared can be used to determine why the price of an investment has changed.

Systematic RisRisk. Unsystematic Risk

Risk management can be divided into two categories: systematic risks and unsystematic risks. Both types of risks can be present in every investment, but they vary depending on the type.

Systematic Risk

The market as a whole is subject to a seismic risk. This Risk is unpredictable and irreversible. It affects all securities. Hedging can reduce systematic Risk. A political upheaval, for example, is a systemic risk that can impact entire financial sectors, such as the stock, bond and currency markets. All securities in these sectors could be negatively affected.

Unsystematic Risk

Second, the unsystematic category is specific to an industry or company. Diversifiable risks can also be reduced by diversifying assets. If you invest in a company like an oil company, then you are assuming the risks of the entire energy sector.

You can hedge your portfolio against unsystematic risks by purchasing a put option for crude oil or on the company. The goal is to minimize portfolio exposure to oil and a specific company.

Risk Measuring Example

Consider an investment that has an excess return (or profit) of 12% and a standard error of 15%. The Sharpe ratio is 0.8. This shows the return on investment. Risk is every unit of Risk. This metric allows you to gauge how well the investment balances risk and reward.

If an investment has a return average of 10% and a standard deviation between 5% and 15%, the majority of returns are likely to fall in the range from 5% to 15%. You can then understand the Risk and variability of the investment.

Risk Measurement vs Risk Assessment

Risk measurement is usually done using tools and metrics like the ones above. This process produces numerical values that indicate the level of Risk associated with a particular investment. Investors can compare the risks of different investments using these values and make data-driven decisions. It is important to understand Risk in a precise and concrete way through data.

Risk assessment is a more comprehensive process that focuses on identifying, analyzing, and prioritizing possible risks. It involves identifying the sources of risks, evaluating their potential impact, and deciding the best strategies for mitigating or managing them. Risk assessment is qualitative and strategic and often involves scenario analysis and expert judgement.

Why is Risk Management Important to Business?

When choosing securities or funds, it is important to consider the risks involved. The magnitude of potential losses should be considered rather than the projected return of an investment.

What is Risk Tolerance?

Your risk tolerance, or the amount of potential peril that you are willing to accept, is a key factor in determining what and how to invest. It is different from your financial risk capacity. The first refers to your comfort level, while the second is more concerned with how much money you are willing to risk.

What is the risk-return tradeoff?

Investors are compensated when they seek higher returns by taking on additional risks. Stocks, for example, are more risky than bonds in general but also offer higher expected returns.

The Bottom Line

Investors tend to be more concerned about returns and less worried about investment risk. Risk management should be at the core of all investment strategies. The measures we’ve discussed will help you to do that. Investors will be pleased to know that many financial platforms calculate these indicators for them. Many investment research reports also include them.

These methods, which range from the standard deviation to beta and even more complex measures such as Value at Risk and Conditional Valuation at Risk, provide a new perspective on investment risks. Combining these tools will give you an overall view of the asset.

SponsoredTrade On The Go: You can trade anywhere, anytime. One of the largest crypto-asset exchanges in the world is waiting for you. Trade with confidence and enjoy competitive fees, dedicated customer service, and secure trading. Binance’s tools will make it easy for you to manage your auto-investments and view price charts. You can also make conversions without any fees. Join millions of investors and traders on the global crypto markets by creating a free account.