Tools for Quantifying Investment Risk (1)

To measure risk, the following analytical tools are relevant and can help you distinguish between stable investments and the overly risky ones.

No doubt, one of the most important things to determine in an investment is the level of risk it comes with. The risk element as well as the possible outcome is what helps you manage your expectations and also guides your decision making process in whatever form of investment vehicle you choose to take.

Even though diversification of your investment portfolio can reduce a level of risk, there will always be other forms of risk you probably cannot determine without financial analysis.

To measure risk, the following analytical tools are relevant and can help you distinguish between stable investments and the overly risky ones.

Capital Asset Pricing Model

One of the commonest methods of determining risk in finance is the Capital Asset Pricing Model (CAPM). CAPM is simply a model that describes the relationship between the expected return and the systematic risk of investing in a security – principally stocks.

The tool helps investors measure the risk and the expected return of an investment to price the asset appropriately. In particular, investors must be compensated for the time value of money and risk.

As such, the risk-free rate is used to represent the time value of money for placing money in any investment. The idea is that investments that are riskier will generally earn a premium in possible returns than stocks or securities with less risk.

R-Squared Or Coefficient Of Determination

R-Squared or coefficient of determination is another tool used by your favorite analysts to determine the level of riskiness of your investment. Without trying to sound too technical, this tool simply helps you determine the correlation between two variables.

The tool measures the movement of an investment security in relation to a benchmark. Where a high R-squared is gotten, it means that the portfolio’s performance is in line with the index and vice versa.

Analysts and advisors use this to come up with a holistic picture of the performance of an investment security.

Standard Deviation

Another very common tool that you probably have been taught at some point in your life or the other, is standard deviation. This tool is typically regarded as a measure of dispersion because it helps you determine how close or far apart a set of values are from themselves.

When it comes to risk assessment, this tool helps you determine volatility. As opposed to comparing the risk to a benchmark, it compares volatility to the historical returns of the security.

This is drawn again from the face that where the returns are really high, risk is imminent and vice versa. High standard deviations reveal high volatility, and lower ones will show you the stable securities with less risk.

The above tools help financial experts measure risk and reward with the goal of differentiating volatile assets from the stable ones. In our next post, we will review some more tools for risk assessment.

Written by Lawretta Egba