Risk is inevitable and natural. It affects every investment decision you make as an investor. There is no solution to escape investment risks. Your best hope is to manage risk effectively.
What is a risk assessment? Well-managed risk is beneficial in the long run, as risk and return go hand in hand. Hence, risk measurement is a kind of risk assessment procedure which is the first step towards making a wise investment decision and building a well-managed investment portfolio. Let’s understand the types of risk assessment.
Types of Risk
Risk can be of two types:
- Qualitative risk
- Quantitative risk
This type of risk is based on these factors:
- Financial goals
- Time horizon
- Risk tolerance capacity
- The risk of the investment itself
How to do a risk assessment? The nature of the investment and its historical performance need to be considered in order to analyse the risk. This can help you compare different investments too. For instance, you have two investments. The investment that has steadily given you a return of 10% year on year is considered less volatile and risky. On the other hand, the second investment gives fluctuating returns, 14% one year, 4% the next year and 10% hereafter. Here, the second investment is considered volatile and a high risk investment option.
Quantitative risk assessment
Besides qualitative approach, risk can also be quantified using analytical tools. Thus, in quantitative risk management, risk is calculated on the basis of certain formulae. Some of them are:
• Standard deviation
It’s a commonly used statistical tool for measuring risk. Basically, standard deviation is used as a measure of volatility in stocks, stock portfolios and mutual funds. This number indicates how much a particular stock/fund return has varied from its average return over a number of years. An investment is considered risky if its return deviates more from historical averages.
For example, stock A and B have given an average return of 10% for last 5 years. But stock A is more risky than stock B as its standard deviation is more and the stock is highly volatile.
Let’s take a look at the performance comparison of the above table in a graphical manner below. The standard deviation graph suggests that stock A is prone to fluctuations as compared to stock B.
Alpha measures investment performance on a risk-adjusted basis. Basically, Alpha means the excess return for any investment as compared to its benchmark performance, thus keeping the risk under adjustments.
Therefore, Alpha of more than 1.0 implies that an investment has outperformed its benchmark and compensated more than that of the risk taken.
Beta gives an idea of historical volatility. It is used to measure how a stock or a portfolio moves in comparison to benchmark index. For example, beta 2 implies that a particular asset is twice as volatile as the benchmark. Beta shows how sensitive an asset is to market movements.
R-squared helps you gauge to what extent the investment portfolio movement reflects on the benchmark movement. The figure may vary from 1-100%. A higher percentage denotes good correlation between portfolio and benchmark return.
Sharpe ratio is one of the widely used tools in tracking the performance of an asset. It is a risk adjusted measure of return that helps to compare two similar investments. In mutual funds, two funds are compared on the basis of Sharpe ratio. The fund having a higher Sharpe ratio is considered worthwhile.
VIX is a widely used measure of market risk. It was introduced in India in 2008 by the National Stock Exchange. VIX measures near-time or upcoming risk. It is based on future and options data and hence gives an approximate idea of near-time volatility expected in the market.
In a nutshell, a correct blend of both qualitative and quantitative risk measurements is ideal for performance assessment and to construct a healthy investment portfolio. It is always good to use more than one mathematical measure to analyse risks. Risk measurement techniques are useful in evaluating the risk associated with an investment, thus helping you analyse and compare to make a smart investment decision.