In the investing world, risk and reward are intertwined. The higher the risk, the higher the potential reward.
To get a better reading on both, many financial professionals choose to rely on a set of statistical measures to guide their investment decisions.
Understanding Risk
Covestor manager Robert Sloma, who oversees the Aggressive Stock portfolio, recently delved into the general concept of risk-adjusted return.
Broadly speaking, this covers an array of mathematical relationships that compare the returns of portfolios with different risk levels against a benchmark like the S&P 500 Index and Dow Jones Industrial Average.
Robert’s post stirred interest, so let’s lift some of the fog surrounding related financial market concepts that help investors understand risk.
Here are five key concepts the money pros watch:
1) Alpha
Want an accurate reading of how your investment or portfolio is really doing? A good place to start is alpha, a measure of an investment’s risk-adjusted performance compared to a benchmark, such as the S&P 500.
Why does Alpha matter? It’s a true indication of what a portfolio manager actually brings to the party. In a rising market, it shows whether your financial adviser is outperforming the broader market or just going along for the ride. How much risk did he or she use to get there?
In a declining market, a talented money manager can deliver less-than-average losses. Alpha can measure that, too.
A positive alpha of 1.0 means the fund or stock has outperformed its benchmark index by 1 percent. A similar negative alpha shows underperformance of 1 percent.
2) Beta
The Alpha calculation, in addition to benchmark analysis, also takes into account beta, a measure of the volatility or the market risk of an investment compared to the rest of the stock market.
Alpha is sometimes called beta-adjusted return. Investors can better compare portfolio managers if they understand the return they generated and the market risk they tolerated to achieve that performance.
Take the case of two hypothetical portfolio managers, Josh and Elena. Let’s assume, both delivered the same 2% annual return over and above the S&P 500 Index last year, but Josh used a far riskier strategy to get there.
In this case, Elena’s alpha would be higher than Josh’s, since she delivered a more-than-expected return with less risk.
3) r-squared
Another measure the financial experts scrutinize is r-squared, which examines the correlation of a portfolio’s price trends with a benchmark. Unlike alpha, this isn’t a performance measure. It tracks movement not relative return.
This statistic is expressed in percentage terms along a range of 1 to 100. An r-squared reading of 70% to 100% means your portfolio or stock tends to move in the same direction (up or down) as the benchmark. A reading of 40% or lower, suggests a very low correlation.
Why does this matter? Investors want to know how much of their portfolio’s performance is explained by broader market movements.
Also, sometimes its advantageous to have an investment that zigs when the broader market zags. You can have a dynamite portfolio with a low r-squared reading that is completely out of sync with the general market.
Think of the hedge fund managers who shorted the housing and stock markets during the 2008 and 2009 financial crisis. It was a lucrative time to be a contrarian.
4) Standard deviation
In a financial market context, the standard deviation is a measure of how much an investment or fund’s returns varies to its mean or average.
This is also a useful measure of risk. It gives investors a sense of how steady a fund’s returns have been over a particular time frame, both on the upside and the downside. Research firms like Morningstar calculate standard deviations for the funds it tracks over a 36-month period.
Consider this example: Over a three-year period, a portfolio that generated 7% returns every year (or for that matter lost 7% of its value every year) would have a standard deviation of zero.
That’s because there is no variance or change in returns from one year to another.
Now, let’s look at a fund with 8% average annual returns over three years but with a standard deviation of 4.
In this case, an investor could reasonably expect that most of the time this fund’s return would vary between 4% and 12%–that is, 4% above or 4% below its average annual return of 8%
5) Sharpe ratio
Finally, there is the more granular, risk-adjusted measure known as the Sharpe Ratio that was developed by Nobel Laureate William Sharpe, a Stanford University finance professor.
In a broad sense, this statistic helps investors figure out how much return they’re getting in exchange for the level of risk they’re taking on.
It’s a little bit complicated but the basic idea behind the ratio is this: First you consider how a fund performed but immediately subtract that return by the amount an investor would have earned in a risk-free investment, perhaps a three-month Treasury bill, over the same period.
Take that number and divide it by the portfolio’s standard deviation (see above). The higher the Sharpe ratio, the more an investor is compensated for the risk he or she takes on.
The Sharpe ratio and other risk measures are key checkpoints to determine whether your manager is a rock star or laggard and whether the risk being taken on is reasonable given the return.
Sure, the math can sometimes be a little mind-bending. Still, it sure beats flying in the dark.
Continued Learning: Covestor manager Robert Sloma explores the concept of risk-adjusted return.
Disclaimer: All investments involve risk and various investment strategies will not always be profitable. Past performance does not guarantee future results.
