In my article “What is Investment Risk” I elaborate the different kinds of investment risk associated with investments into publicly listed securities as well as mutual funds and ETFs. Since understanding the risks implied for a portfolio is key for the success of an investment strategy, it is worthwhile to shed a light on the common risk measures to evaluate risk. There are several measures to evaluate investment risk from different angles, since each of the measures provides different insights into the potential risks associated with an investment. Even as the list below may not be complete, it includes some of the most used risk measures:
Volatility
The most cited risk measure is the volatility, which is a statistical measure used to gauge the amount of variability or dispersion of investment returns around the mean price for any given security or market index. From a mathematical point of view, the volatility is the annualized standard deviation.
With regard to this, volatility often refers to the amount of uncertainty or risk related to possible changes of the value of a security. Since higher volatility means that the value of a security can potentially spread out over a larger range of values compared to those securities with a lower volatility, a higher volatility is considered as a higher risk than a lower volatility. In other words, the price for securities with a higher volatility may fluctuate dramatically, while the price of securities with a low volatility tends to be steadier.
An increased volatility is seen as a sign for fear and uncertainty amongst equity investors, therefore the VIX volatility index is also called “fear index.”
Maximum Drawdown
The maximum drawdown is a very simple risk measure as it refers to the largest peak-to-trough decline in the value of a security or portfolio over a specific period. With regard to this, it indicates the maximum loss which investors in the respective security or portfolio have experienced over the defined time period. That said, investors should use the longest possible time period for the evaluation of the maximum drawdown since this would ensure that all drawdowns a security has faced in the past are considered within the evaluation.
Beta
The beta (coefficient) is a risk measure which measures the sensitivity of an individual security or portfolio returns relative to the returns of the index used as benchmark for the respective security/fund/portfolio. Therefore, it can be said that beta denotes the systematic (market) risk or volatility of a security or portfolio compared to the market (index). With regard to this, the market (index) defines the baseline and has a beta of 1. A beta greater than 1 indicates that the security or portfolio is more volatile than the market, while a beta less than 1 indicates less volatility.
Tracking Error
The tracking error measures the deviation in the price/performance behavior of a security or portfolio versus the price/performance behavior of its benchmark. It is defined as the standard deviation of the difference between the portfolio and the benchmark returns over time. In other words, it is actually the performance difference between a single security or a portfolio and its corresponding benchmark. With regard to this, the tracking error measures how closely a portfolio follows its benchmark. This means the tracking error can also be viewed as an indicator of how actively a portfolio (fund) is managed against its benchmark. A higher tracking error indicates greater divergence from the benchmark and therefore a potentially higher risk/chance of a higher/lower performance of the portfolio relative to its benchmark.
In addition to this, there are also some more advanced risk measures which are used by professional investors. One of the widest used advanced measures is the Value at Risk (VaR).
Value at Risk (VaR)
The VaR estimates the potential loss in value of an investment or portfolio over a defined time period for a given confidence interval. Therefore, the value at risk is a way to quantify the risk of potential loses for a portfolio. For example, a 5% VaR of $1 million means there is a 5% chance the portfolio will lose more than $1 million over the specified period.
Investors have to be aware that the VaR can be calculated with three different methodologies:
- The historical method, which follows the assumption that past returns will inform future outcomes.
- The variance-covariance method, also known as parametric method, assumes gains and losses are following a normal distribution. As a result, potential losses can be framed in terms of standard deviation events from the mean.
- The Monte Carlo Method, which uses computational models to simulate projected returns.
The advantage of the VaR is that it is a single number, expressed as a percentage or price/money units, which is easy to interpret. Another advantage is that value at risk calculations can be compared across different asset types.
The biggest disadvantage for the value at risk can be seen in the fact that there is no standard protocol for the statistics used to determine the risk of a security or portfolio. Periods of low volatility may understate the potential for risk events to occur. In addition, the use of normal distribution probabilities may lead to a further underestimation of risk, since they rarely account for extreme, the so-called “black swan” events.
That said, investors need to bear in mind that calculated loss at a given confidence interval represents the lowest amount of risk in a range of possible outcomes. With regard to this, the Value at Risk is often criticized for offering a false sense of security, since the VaR does not report the potential maximum loss.
Conditional Value at Risk (CVaR)
The CVaR is also known as Expected Shortfall. It measures the average loss that exceeds the VaR, quantifies the amount of tail risk or the risk of extreme losses for a given portfolio. The conditional value at risk is derived by calculating a weighted average of the “extreme” losses in the tail of the distribution of possible returns, beyond the VaR cut-off point. With regard to this, it can be said that the CVaR may lead to a more conservative approach in terms of risk exposure, especially for engineered and/or volatile investments, compared to the VaR.
As stated above, this article does only review the most common risk measures. Therefore, not all measures available to evaluate investment risk are mentioned in this article. Investors or their advisors may choose other risk measures, as they might be more suitable for the individual investor.
Using a combination of these measures can provide a comprehensive assessment of the respective investment risk and help investors make more informed decisions.
That said, the result of an evaluation of the performance of a fund/ETF with a combination of a risk and a return measure is called risk-adjusted returns. There are several well known risk-adjusted return measures, which will be explained in another article.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of Lipper or LSEG.
