Before making serious investment decisions, it is very important that you consider common ways to measure investment risk management. And this process often requires identifying and analyzing the level of risks that would be involved in an investment either you choose to mitigate or embrace such risk. Conditional value at risk (CVaR), Beta, standard deviation, and value at risk (VaR) are some common metrics used in risk management.
Here Are Some Of The Popular Metrics Used In Risk Management
1. Sharpe Ratio
The Sharpe ratio is used in the performance measurement as it is adjusted by associated risks. This involves deducting the rate of return on an investment that is risk-free, e.g. U.S. Treasury Bond, from the rate of return experienced.
Thereafter, it is divided by the standard deviation of the associated investment. And it serves as a measurement of whether a return of investment is due to the assumption of excess risk or due to wise investing.
Scortino ratio is a Sharpe ratio variation. The Scortino ratio removes the impacts of an increasing price movements on standard deviation to put more emphasis on the distribution of returns which fall below the required or target return.
It additionally replaces the risk-free rates with the required return in the formula’s numerator, and that makes the formula the portfolio’s return fall less than the return required, divided by distributing returns less than the required or target return.
Treynor Ratio is another variation of the Sharpe ratio. It uses the portfolio’s correlation or beta which the portfolio earns with the remaining aspect of the market. Beta is a weighing metric of the volatility of an investment and risk as compared to the market’s totality. The Treynor ratio has a goal of determining if there’s a compensation provided for an investor for additional risks taken above the existing market risk. The Treynor ratio formula is hence the division of the portfolio’s beta by the return of the portfolio’s less the risk-free rate
2. Standard Deviation
This metric is a way to measure investment risk management of the dispersion of the data as against its expected value. As a way for making decisions on investment for measuring the historical volatility amount connected with an investment which is relative to the return of its annual rate. This is an indicator of how much deviation is experienced by the current return from the historical normal return expected. For instance, there would be an experience of higher volatility by a stock that has a high standard, and hence, there is a higher level of risk of which the stock is connected with.
Those who have interest solely in the potential losses while neglecting the possibility of gains, the standard deviations is essentially graced to the downside by the semi-deviation.
3. Value at Risk (VaR)
This is a kind of statistical measure which is used to measure the level of risk that is related with a company or portfolio. The VaR takes measures of the maximum potential loss with a level of confidence for specific length of time. For instance, assuming a portfolio of investments has one-year 10 percent VaR of $5 million, in essence, there is a 10% chance that the portfolio has before losing over $5million in a one-year span.
Another common measure of investment risk management is Beta. And it measures the amount of systematic risk an industrial sector or security individual possesses in relation to the total stock market. The market, having a beta of one can be harnessed in weighing the potential security risk. So, if the beta of a security equates to 1, the security’s place steps in time with the market. And when a security has a beta which is greater than 1, it indicates that it is very much volatile compared to the market.
And if a security’s beta drops less than 1, that shows that it is less volatile compared to the market. An instance is if a security’s beta is 1.5, theoretically, such security is 50% of more volatility compared to the market.
This is a form of statistical measure that stands as the percentage of a security movement or fund portfolio which can be illustrated by the movements in a benchmark index. As fixed income securities and bond funds, the U.S. Treasury bill is the benchmark. The benchmark for equity funds and equities is the S&P 500 index.
The range of R-squared is from 0-100. Morningstar states that a mutual fund that has an R-squared value between 85 and 100 is with a level of performance record which is very much correlated to the index. A fund that has a rate of 70 or less, doesn’t perform like the index.
When it comes to high R-squared ratios, investors of mutual funds ought to refrain from actively managing funds that are generally decried by analysts as being “closet” index funds. It makes little to no sense to make higher payment in such cases for professional management when you could have earned even better results harnessing an index fund.
6. Conditional Value at Risk (CVaR)
Conditional value at risk (CVaR) is used in assessing an investment’s tail risk. Employed as an investment’s tail risk, CVaR makes assessment of the likelihood with a level of confidence that a break in the VaR will be made; that seeks to make assessment of what happens to investment that is well beyond the loss threshold maximum.
This measure gets more sensitivity to occurences at the later end of the distribution, which is the tail risk. For instance, if a particular risk manager takes an average investment loss as $10million for the worst 1% of most likely outcomes for a particular portfolio. Hence, the expected shortfall or CVaR is $10million for that one percent tail.
Risk Categories You Should Know
So, aside the outlined measures, there are two broad categories of risk management. They are systematic and unsystematic risk
Systemic risk is a kind of risk management that affects the totality of the market of the security. It is market associated, undiversifiable, and unpredictable. However you can minimize the risk effects via hedging. For instance, disruptions in the polity isa systematic risk which can affect badly on multiple financial markets, such as currency markets, bonds, and stock. A way an investor can hedge against this kind of risk is by buying put options in the market itself.
Unsystematic risk is connected with a sector or company, and it is known as diversifiable risk which can be mitigated using diversification of assets. This kind of risk is feasible in a specific industry or stock. An investor who buys oil stock would assume the risks connected with the company and the oil industry.
For instance, if an investor who is investing in an oil company, and thinks that the oil company’s oil prices would impact negatively on the company, he may consider hedging, or taking the opposite side by making purchase of a put option on the company or on crude oil. He may also consider looking to control the potential risk by harnessing diversification through buying stock in airline companies or in retail.
He would mitigate some of the potential risks harnessing this medium to secure his exposure to the oil industry. If he gets less worried about risk management, the stock and oil prices of the company could experience a significant drop, and that could lead to the investor losing the totality of his investment. And that could deal a huge blow on his portfolio.
In conclusion, a lot of investors put their focus less on investment risks, but exclusively on investment returns. And the itemized risks can make available balances to the equation of the risk return. As an investor, one advantage you have is that these risk indicators are calculated and also made available on various online platforms for use. And they are also being incorporated into different investment research reports.
As resourceful as the risk measurements portend when you are considering mutual funds, stock, or bonds, it is much important to know that volatility risk is just one of the key factors that can impact investment quality.