Risk Metrics Explained
When analyzing an investment strategy, risk is a primary consideration. But what exactly is risk? And how can we measure it?
Risk, at its most basic level, is the potential of losing something of value. We value many things, including our physical and emotional health, social status, and financial wealth, among others. When it comes to investing, risk is generally thought of as the potential of our investments to decline in value. However, severe swings in our financial well being can impact our physical and emotional health. There is more on the line when it comes to investing than just money.
Risk is a nebulous concept, as it deals in the realm of probabilities and statistics. Modern finance has attempted to measure and analyze risk in nearly every way imaginable, and yet quantification methods remain far from perfect. As a result, there are variety of approaches to measure and interpret risk. We’ll explore some of these key metrics below.
Risk and reward go hand in hand. There are many different approaches to investing, and each comes with a different relationship between risk and reward. For example, one strategy may outperform another, but if that strategy entails significantly higher risk, is it still a better alternative? Combining risk and reward to decipher risk-adjusted returns can be a huge advantage when it comes to comparing one investment strategy against another.
When evaluating an investment strategy, using multiple assessments of risk can paint a much clearer picture than focusing on just one or two.
Standard deviation is the most common measure of risk used in the financial industry. Standard deviation measures the variability of returns for a given asset or investment approach. If an asset’s value exhibits large-magnitude swings up and down (high volatility), it will have a higher standard deviation, and correspondingly more risk than a stable asset whose value remains more constant. Standard deviation is expressed as a percentage, and represents the extent to which returns deviate from their average, over a given time frame.
Implications: Lower standard deviation implies less risk, higher standard deviation implies more risk.
Considerations: Standard deviation assumes that returns are normally distributed, which is not always the case. If returns are not normally distributed, the standard deviation can be a bit misleading. Standard deviation also treats upside and downside volatility equally.
Beta is a measure of volatility, similar to standard deviation, except that beta measures volatility in relation to the market as a whole. An investment strategy’s beta will tell you how volatile it is when compared to the broader market. A beta of 1 means that the strategy has the same volatility as the market. A beta of less than one indicates lower volatility than the market, while a beta greater one indicates higher volatility than the market.
Implications: A higher Beta implies more risk, a lower Beta implies less risk.
Considerations: Beta measures volatility in relation to the market. Choosing an appropriate benchmark is crucial for Beta to be meaningful. For most stocks and stock portfolios, the benchmark used is the S&P 500. In some cases, Model Investing lists the Beta for a bond or bond related portfolio. While it may be more meaningful to list the Beta compared to a bond benchmark, we have instead shown the Beta in relation to the S&P 500. This results in a very low Beta and is done to demonstrate that those bond portfolios have much lower volatility than the broader stock market.
This metric is a simple indicator of risk that is both intuitive and easy to understand. Maximum drawdown measures the greatest peak-to-trough decline that an investment strategy experiences over time. Maximum drawdown is expressed as a percentage and reflects the largest price move down from a new high.
Implications: Lower maximum drawdown implies less risk, higher maximum drawdown implies higher risk.
Considerations: Maximum Drawdown measures the largest one-time decline, but provides no indication on the frequency of similar magnitude declines. By looking at maximum drawdown in conjunction with a measure of volatility, such as standard deviation, a better assessment of risk can be made.
The Sharpe ratio is the industry standard when it comes to measuring risk-adjusted return, which is the average return earned in excess of the risk-free rate, per unit of volatility. Said another way, the Sharpe ratio tells you the effectiveness of an investment strategy at generating returns for a given level of risk. It illuminates whether a portfolio’s excess returns are due to strategic decisions or a result of taking on increased risk.
Implications: A higher Sharpe ratio implies a higher risk-adjusted return, a lower Sharpe ratio implies a lower risk-adjusted return.
Considerations: The Sharpe ratio uses standard deviation as part of its calculation, resulting in subtle discrepancies if the returns are not normally distributed. It also treats upside and downside volatility equally.
The Sorentino ratio is a variation of the Sharpe ratio, which removes the impact of upward price moves. When the value of an investment or investment strategy moves higher, it’s desirable, and so it makes sense to exclude the effects of upward price volatility when measuring risk. The Sorentino ratio does this by utilizing downside price volatility instead of overall volatility.
Implications: A higher Sorentino ratio implies a higher risk-adjusted return, a lower Sorentino ratio implies a lower risk-adjusted return.
Considerations: Sorentino ratios require sufficient negative returns in order to calculate. As a result they are not always available. In most cases volatility is more or less symmetrical, making the Sharpe ratio a suitable proxy.
The Treynor ratio is another measure of risk-adjusted return that utilizes a slightly different approach than the Sharpe and Sorentino ratios. This risk metric compares the returns earned in excess of the risk-free rate with the beta of the investment strategy.
Implications: A higher Treynor ratio implies a higher risk-adjusted return, a lower Treynor ratio implies a lower risk-adjusted return.
Considerations: The Treynor ratio, like the Sorentino and Sharpe ratios, means nothing on its own. It is only useful when comparing two or more investments or investment strategies.