Investment experts say that returns and risk go hand in hand. When it comes to investing, risk is defined as the possibility that an investment's actual return will vary from its expected return. This includes the unfortunate possibility of losing some or all of the original investment you made. Risk can emanate from various sources – change in the economy or market forces which in turn impact a business, business cycles, regulatory changes, changes in interest rates, investing styles, etc. That is why asset management companies publish risk measures in scheme related documents. So that you can make a more informed decision. So what are some popular risk measures that you should understand?
Types of risk measures:
Alpha is a mathematical measure of the out-performance of an investment as compared to the market or a benchmark index, on a risk-adjusted basis. The resulting excess return is the Alpha. Higher the Alpha, the better your investment has performed against the index. Remember that the benchmark index refers to any chosen market index such as the S&P BSE Sensex or the Nifty 50, against which you can compare how your investment is performing. So Alpha is calculated simply by deducting the benchmark return from the investment return. For instance, if the benchmark delivered 8 per cent and your mutual fund investment gave you 10 per cent returns, Alpha will be 2 per cent. This simply means that the fund manager, through his actions, was able to outperform the benchmark by 2%. In general, a higher alpha is a good indicator of performance.
Beta is a measure of the volatility involved in investing in a security compared to the market as a whole. It indicates how likely the investment is to experience wide swings in value. A beta of 1 suggests the fund is as risky as the market. If the market goes up the fund will also go up following the same pattern. A beta exceeding 1 indicates that the fund will swing more than the market while a beta of less than 1 indicates that the fund will swing to a lesser degree than the market. In general, risk averse investors prefer investments with lower beta values because when the market goes down chances are that their investment value will fall lesser than the overall market. On the other hand, those who are willing to take more risk can choose investments with higher Beta values because when the market goes up, their investment value could potentially rise more than the market.
R-Squared is not a measure of performance but of correlation to the benchmark’s performance. The performance is measured from 1 to 100, with 100 being the most correlated. Correlation is the relationship between movements of a fund and the movements of a benchmark index. For example, if the accepted benchmark index for equity investing in India is the S&P BSE Sensex, an equity mutual fund which shows its correlation as 100 is perfectly aligned to the performance of the Sensex. To conclude, higher R Squared values mean better correlated performance with the investment’s benchmark.
Standard Deviation is the historical volatility in an investment product and is measured by calculating the average variation from the mean returns over a given period of time. For instance, let’s say you invested in Stock A for a 5 year time period and the mean return over the 5 years was 20%. There would have been times that its performance went as high as 70% and there would be times it performed poorly, reducing your returns to just 5%. Which means that the stock is very volatile, and has a high standard deviation. On the other hand, let us look at Stock B. The stock price has also gone up and down but not as sharply as Stock A’s. Therefore its standard deviation, and hence its volatility would be much lower. When we compare the two stocks, one can observe that that high standard deviation could potentially help earn higher returns but there will be a lot of risk involved. On the other hand, lower standard deviation may deliver lower returns but there is lesser risk involved. Your own risk profile will determine how you can view an investment product’s performance potential through the lens of standard deviation. In general, investors prefer investments with lower standard deviation as their performance is generally more predictable.
Sharpe ratio measures the risk taken in order to achieve higher returns. If risk is measured by standard deviation, Sharpe ratio measures the excess return over the risk-free rate of return offered by risk-free investments (this is considered as government bonds). The higher the ratio, the better the risk-adjusted return or in other words the potential of earning better rewards, per unit of your risk exposure. This measure is particularly useful if you are looking at investing in very high risk assets.
Treynor Ratio is the measurement of the efficiency of an investment per unit of risk, using beta as the measure of risk. This measurement shows returns above the risk-free rate of return offered by risk-free investments (government bonds), measured relative to the local market risk. A high Treynor ratio is an indicator of an investment generating better returns despite the volatility present in the market.
In summary, a higher Alpha, Sharpe Ratio and Treynor ratio indicate better potential performance, lower Beta and Standard Deviation indicate lower volatility and a higher R-Squared indicates a better correlation with the benchmark. Together, these risk measurement tools available, both Alpha and Beta have become more popular ways of measuring risk, and can be seen on mutual fund factsheets. In general, risk measurement tools enable the investor to better understand the returns generated by the fund and also the “value-added” returns that a fund manager generates for a fund. So when considering an investment product, don’t make a decision based solely on performance.
Understand the various risk measures and ratios and discuss them with your investment advisor.
- Risk is defined as the chance that an investment's actual return will vary from its expected return.
- High Alpha, Sharpe Ratio and Treynor Ratio indicate better potential performance, low Beta and Standard Deviation indicate low volatility and a higher R-Squared indicates a better correlation with the benchmark.
- The combination of a number of risk measurement tools can help you to understand volatility, historical returns and a fund manager’s value added performance.