Investment Risk Metrics

There are several risk metrics that measure the historical volatility of portfolios of securities. Unfortunately, like track records, these metrics do not have any significant predictive value. A portfolio have lower risk characteristics than the market and still lose more in a down market and make more in a rising market.

We are going to focus on the meaning of four of the more frequently used risk metrics.

Beta

A measurement that compares the volatility of your portfolio to the volatility of the market (S&P 500). The market has a beta of 1.00. If the beta of your portfolio is 1.10 you are 10% more volatile than the market. Therefore, you should make more in rising markets and lose more in falling markets. High beta portfolios are considered high risk. 

Alpha

Alpha is the risk adjusted performance of your portfolio compared to a benchmark like the S&P 500. Positive Alpha means your porfolio outperformed the benchmark. Negative alpha means your portfolio lagged the performance of the benchmark. Positive alpha is said to be the value that is added by active portfolio management.

Standard Deviation

Standard deviation is the dispersion of rates of return over time. The greater the dispersion, the higher the standard deviation, the greater the risk. Lower standard deviations represent more stable, conservative rates of return. For example, a large utility stock will have a lower standard deviation than a small capitalization, growth stock in the technology sector.

Sharpe Ratio

A ratio that measures risk adjusted performance. It is calculated by subtracting a risk free rate of return (two year government bonds) from a portfolio's return and dividing the difference by the portfolio's net returns. The goal is to determine if the incremental portfolio return was produced by good decisions or excess risk. 

Paladin says.....

As noted risk metrics do not have predictive value. But, they are excellent tools for comparing the historical risk and performance of money managers, mutual funds, and your portfolio. There is always the assumption that the money manager who produced the best results for the lowest risk in the past will re-produce those results in the future.