Build an Effective Portfolio: Understanding Measures of Risk

Investors constantly look for new ways to measure and manage the many risks affecting a portfolio. However, in order to manage risk, an investor must be able to identify it and have some methodology for measuring its reduction.

The standard risk reduction strategy is portfolio diversification. Diversification attempts to reduce potential loss by using a selection of assets. By reducing the prospect of suffering losses from one asset, the portfolio has reduced risk. Some studies have shown that a portfolio of stocks begins to experience the benefits of diversification with just a few stocks in the portfolio, provided that the assets in the portfolio provide adequate diversification. However, in order to actually reduce portfolio risk, it is necessary to combine assets that complement each other.

Correlation

Correlation measures the covariance between two assets and is expressed as a number between -1 and 1. Zero expresses no correlation, with 1.00 expressing perfect correlation (the assets will always move in the same direction) and -1.00 expressing perfectly non-correlated assets. Ideally, a portfolio should contain assets that have low, zero, or negative correlation. By reducing the correlation between assets in the portfolio, the investor can achieve reduced risk and improved returns.

Standard Deviation

The dispersion of data surrounding an asset’s mean price, systematic risk. Standard deviation provides a likely range of prices or returns above and below the average price or return. The greater the standard deviation of an asset, the more volatility it will see.

Beta

Beta measures the change in a stock’s price given a change in the price of the broad market. A stock with beta of approximately 1.0 moves in the same direction and magnitude as the general market. Stocks that move less than the general market (defensive stocks) have a beta of less than 1, while stocks that move more than the general market (aggressive stocks) have a beta of greater than 1. Of course, using beta to measure risk makes the assumption that history will repeat itself, which it may not.

Alpha

Alpha measures a stock’s performance compared to its benchmark on a risk-adjusted basis. A stock with an alpha of 1 indicates the stock outperformed its benchmark by (1%); an Alpha of -1 indicates that the stock underperformed its benchmark by (-1%).

R-Squared

How much of a stock’s performance can be explained by the performance of a particular benchmark index. The data ranges from 0-100; a value of 100 indicates that the stock’s performance is directly correlated with the benchmark index. Typically a stock that has an R-Squared between 75 -1 00, behaves like an ETF to the index being measured. As an investor, who has a stock with an R-Squared of 75 – 100, it might be economical to move to an ETF since they have lower management fees compared to an actively managed fund.

Sharpe Ratio

Sharpe Ratio measures how much of the stock’s performance is due to good management rather than systematic risk. It is calculated by subtracting the rate of return for a risk-free investment (i.e. Canada Savings Bond) by the stock’s rate of return, and then dividing by the standard deviation of the stock. The higher the Sharpe Ratio the more its performance is due to good management. The values used in the calculation will be in relation to the time frame which is being measured. ex. 1 yr, 3 yr, 5 yr etc.

** Please note that I have been referring to stocks.  Mutual funds, portfolios etc. can also use the above calculations to measure risk**