In our recent discussion of the values of using risk-adjusted returns to evaluate potential investments, we referenced some individual risk measures that often come in handy to investors. Risk measures are different statistical metrics that can help analysts to gauge an investment’s historical risk and volatility. In this article, we will explain the basics of some of the most common risk measures, so that you might better understand the most frequently used methods of gauging an investment’s risk before you lay down your money for it.
Typically, investors look at four primary risk measures, each of which can be used to individually analyze a stock or can be combined into different ratios (such as the Sharpe ratio and the Treynor ratio we described in more recent articles). Below are brief explanations of each of the four most common risk measures that investors typically turn to when they evaluate their potential investment choices:
Alpha is a measure that shows an investment’s performance relative to that of the entire market, or relative to a selected index. For example, if we wanted to compare an investment relative to the S&P 500, we could measure the activity of the investment over time and compare the activity of the S&P over the same period of time. If the comparison shows that the performance of the investment has been better than the performance of the index over time, we would say that it has a positive alpha value. For some investors, the fact that an investment has a positive alpha value can be a strong indication that an investment might be a good choice.
Beta, much like Alpha, compares an investment to the market. However, instead of comparing total performance, Beta looks at the volatility of the investment compared to the volatility of the market. Beta is represented by a numerical scale, with a Beta of 1 indicating that the investment is exactly as volatile as the market. Betas below 1 are considered less volatile and Betas above 1 are considered to be more volatile than the market. Obviously, this indicator can correspond with an investor’s risk preferences, as Beta can provide investors with a benchmark number with which they can assess the stock relative to their own ability to handle volatility.
R-squared measures how closely an investment’s movements are tied to those of an index – usually the S&P 500, when R-squared values are calculated for securities. For example, if a stock moved exactly with the S&P 500, it would have an R-squared of 100%. However, it is very unlikely for this to be the case. Typically, R-squared values fall somewhere between 30% and 90%, with 90% or higher indicating a very strong correlation to the index, and values below 50% indicating a much lower correlation.
4. Standard Deviation
Finally, calculating the standard deviation of an investment’s movements is one way that investors measure an investment’s volatility. The number is based on the investment’s mean value, and the data points from its upwards and downwards movements are used to give investors a sense of how likely the stock is to shift over time. Investments with high standard deviations are typically more volatile than those with lower standard deviations.
As mentioned previously, all of these tools can be evaluated independently or can be used to calculate various ratios regarding an investment’s risk levels. As always, risk is an extremely important measure when it comes to choosing stocks. Therefore, understanding these basic risk measures can really help newer investors to pick investments that might better suit their investing goals!