All successful investors have to consider risk measurement. The codependency allows investors familiar with risk metrics to invest efficiently. As a result, investment portfolios always consider the level of risk that investors are willing to take. Regardless of the investor’s goals, investment risk management is affected by one’s means of investing. So, then, what is the point of risk measurement? Steady investments.
What is Risk Measurement?
In short, risk measurement is the process that investors use to make investments. Risk measurement involves various factors, known as risk metrics, which determine the quality of an investment. Although investment quality can vary based on the investor’s goals, it is not impossible to judge whether an investment involves high risk. However, the principle of risks and returns states that those significant risks are more likely to be compensated by greater returns. On the other hand, to measure risk in investment means to be aware of the possibility of a loss. Consequently, new investors must know how to measure risk in investment.
Risk Measurement Principles
There are numerous risk measures that investors can choose from when it comes to investing. The selection process may seem daunting at first, although most investors tend to realize which measures work best sooner or later. In order to aid new investors, we have selected the five make-or-break principles every investor should be familiar with: standard deviation, the sharpie ratio, beta, value at risk and conditional value at risk.
By definition, the term standard deviation refers to the act of measuring the degree of variation or dispersion of a set of values. In practice, standard deviation shows how your current return deviates from the expected returns. Most stocks with high standard deviations go hand in hand with high levels of risk. In other words, stocks that experience unsteady highs and lows coincide with greater returns. At least, in theory. As previously mentioned, risk measurement depends on more than one variable.
For an investor to measure risk levels, that investor must also account for potential returns. On paper, the standard deviation is a clear-cut, objective method. In practice, the standard deviation can stop investors from making worthwhile returns. Therefore, standard deviation should not dictate your investments. Currently, many new investors are looking for investment opportunities that involve low risks and high returns. The Statista Research Department’s survey on the Average market risk premium in the U.S. 2011-2021 showed that the United States’ average market risk premium experienced a 5.5 percent decline in 2021 alone. These numbers suggest that more investors expect a slightly higher return for investments to the risk they take, which goes against the principle of balancing risks and returns.
The Sharpie ratio is another method of measuring investment risk. In short, it reduces associated risk by helping investors understand risk as a byproduct of investment. The Sharpie ratio is based on three elements: average return, risk-free rate, and volatility. These elements, along with an investment portfolio’s past and future performance, can be used to assess an investor’s potential returns.
The Sharpie ratio, however, is not without its share of flaws. As is the case with standard deviation, which the Sharpie ratio incorporates, it can be hard to differentiate between risk and opportunity. Specifically, due to its use of both volatility and standard deviation as a means of measuring risk, the Sharpie ratio could occasionally skew an investor’s perception of opportune investments and returns.
As was the case with standard deviation, so is the case with the Sharpie ratio. When it comes to measuring investment risk, most of the tools mentioned are invaluable. Can they be used to measure risk? Yes, absolutely. Should they be seen as an absolute authority? No, they should not. What sets apart a good investor from a great investor is the ability to use, but not necessarily depend on such tools.
Beta is where things get a bit less personal. Compared to the previous two, beta is another measure of risk. Unlike them, investors use beta to measure systematic risk. For those who might not be familiar with the term, systematic risk includes factors such as inflation, interest rates, climate change, natural disasters, and even wars. Investors use beta as a way of comparing investment sectors to each other. Add the stock market as a lens through which the investors view investment sectors, and you get beta.
How is, then, beta used in practice. Imagine the overall market as an entity that has a beta of 1. When an investment (stock) has a beta of 1, that investment will probably move just as much as the market. If the market goes down, your investment goes down. If the market goes up, your investment goes up. In theory, beta is a means of judging stocks.
When a stock has a beta of 0.5, it means that your investment will follow the market’s rise and fall only half as much. That will make the investment much safer, but your returns will be lower. A stock with a value of 2, on the other hand, would be significantly affected by the market. Minor changes will have noticeable effects on your returns. Beta functions the same on a portfolio level. When a portfolio’s beta score is high, it’s because a lot of the portfolio’s elements have high beta scores. Both your portfolios and your investments will be affected by the market. The score only shows the extent of that effect.
Value at Risk and Conditional Value at Risk
As the names might suggest, Value at Risk (VaR) and Conditional Value at Risk (CVaR) are closely related. VaR is a method of measuring investment risk regarding portfolios and companies. Investors use the VaR when compiling their portfolios because it allows them to consider potential losses. Based on the level of risk you are comfortable with, you could choose to invest long term or short term. As an investor, you should be concerned with your maximum potential loss because it affects your returns directly. The more familiar you are with your potential losses, the easier it is to reduce risk.
CVaR is, at its core, an extra layer of security. It shows your portfolio’s likelihood of going beyond your maximum potential losses. These losses are unlikely but are still not beyond the realm of possibility. Norrestad’s paper on the Willingness to take investment risks in the U.S. 2020, by age of household head, shows that only around 40% of millennials and Generation Z are willing to take investment risks. Therefore, for those investors who want to go the extra mile and consider as many risk metrics as possible, CVaR could be a great way to measure risk in investment. Investors should still remember that, unlike VaR, CVaR is a lot more useful for extensive portfolios. Most individuals who have put a considerable amount of their savings into an investment portfolio should aim to reduce risks as much as possible and use CVaR.
All in all, there is no shortage of risk measurement tools for investors to use. All of them serve a purpose. Standard deviation and beta measure statistical deviations, beta, VaR, and CVaR measure market compatibility. Telling investors to use just one way of measuring risk in investment does more harm than good. For most, it would be best to try out these risk measurement tools. The key is not to rely on them more than you have to.
Most of these tools have been around for years. They are not kept hidden from new investors, either. So, why doesn’t every person who invests have an excellent portfolio? Because individual choices still matter, and so does market knowledge. Investors can and should use these tools, but not to the extent that they become entirely dependent on them.