What are the risk measures?
Risk metrics are statistical metrics that are historical predictors of investment risk and volatility, and are also key components of modern portfolio theory (MPT). MPT is a standard financial and academic methodology for evaluating the performance of a stock or equity fund against its benchmark index.
There are five main measures of risk, and each provides a unique way of assessing the risks involved in the investments under consideration. The five measures include alpha, beta, R-squared, standard deviation, and Sharpe ratio. Risk measures can be used individually or together to conduct a risk assessment. When comparing two potential investments, it is wise to compare, for example, to determine which investment carries the most risk.
The main concerns
Risk metrics are statistical measures that are historical predictors of an investment’s risk and volatility.
Risk metrics are also key components of Modern Portfolio Theory (MPT), which is a standard financial methodology for evaluating investment performance.
The five major risk measures include alpha, beta, R-squared, standard deviation, and Sharpe ratio.
Understand risk measures
Alpha measures risk related to a market or a specific benchmark. For example, if the S&P 500 is considered the benchmark for a specific fund, then the fund’s activity will be compared to the activity that the specific index is experiencing. If a fund outperforms the benchmark, it is said to have alpha positive. If the fund’s performance falls below the performance of the benchmark, it is considered to have a negative alpha.
Beta measures the volatility or systemic risk of a fund compared to a specified market or benchmark. The beta version of ONE indicates that the box is expected to move along with the indicator. Versions less than one are less capricious than the standard, while versions over one are more capricious than the standard.
R-Squared measures the percentage of investment movement attributable to moves in its benchmark index. The R squared value represents the correlation between the considered investment and the associated benchmark. For example, an R-squared value of 95 can be considered to be highly correlated, while an R-squared value of 50 can be considered low.
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The U.S. Treasury Act serves as the benchmark for fixed-income securities, while the S&P 500 serves as the benchmark for stocks.
Standard Deviation is a method of measuring the dispersion of data with respect to the mean value of a data set and provides a measure of investment volatility.
In terms of its relationship to investments, standard deviation measures how much the return on investment deviates from the normal or expected average return.
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The Sharpe ratio measures performance according to the risks associated with it. This is done by removing the risk-free rate of return on investment, such as US Treasuries, from the expert rate of return.
This is then divided by the standard deviation associated with the investment and serves as an indicator of whether the return on investment is due to a prudent investment or due to the assumption of excess risk.