Tools for Quantifying Investment Risk (2)

In our last post, we took a look at some of the financial tools used to quantify investment risk. Here, we review more of these tools.

You cannot effectively invest in anything without first determining the level of risk associated with it. While there are generic ways used to roughly determine the level of risk involved like the level of expected income, there are more analytical measures used by financial advisors and experts in determining the level of riskiness involved in any investment.

The goal is to find a level of risk and return that is optimized towards attaining the objectives of the investor. In our last post, we took a look at some of the financial tools used to quantify investment risk. Here, we review more of these tools.

Efficient Frontier

Efficient frontier is a tool that helps the investor determine the lowest risk available for a level of return. This tool takes into cognisance your entire investment portfolio with a goal of determining its efficiency in risk/return and its goal is to optimize returns using the tools of asset allocation and diversification.

Since it reveals which portfolio mix has the highest expected return for a predetermined level of risk or vice versa (that is, the lowest risk for a given level of expected return), anything below the efficient frontier is regarded as sub-optimal as it does not offer a good enough return for the level of risk involved.

This tool is found under the modern portfolio theory and the theory is used to understand the risk of a portfolio in relation to its return.

The Sharpe Ratio

Another important tool for determining the riskiness of an investment security is what is known as the Sharpe Ratio. This ratio is used to measure the performance of one investment when compared to a risk-free security after risk has been adjusted for.

It can also be regarded as the average return earned more than the risk-free based on the total risk and it shows the additional return an investor can receive with the added volatility that comes with holding riskier assets.

As a benchmark, a Sharpe ratio of one or greater is said to have a better risk-to-reward balance.

Alpha and Beta

Alpha and Beta ratios are also very good in determining risk and reward of investment securities. Both ratios are used under modern portfolio theory. Alphas as a tool on its own is used to measure the performance of an investment portfolio and compare it against a benchmark.

It calculates the difference between the return and the benchmark. In other words, if the return of the portfolio is 7 and the benchmark is 6.5, then the alpha is 0.5 (7 minus 6.5).

A positive alpha of 1 reveals that the portfolio has done better than the benchmark and has over performed. However, a negative alpha shows the security has under-performed.

Beta, on the other hand, measures the volatility of the portfolio also compared to a benchmark. Instead of determining just a fixed level of risk, it shows the different movements in asset prices.

Just like alpha, a beta greater than one shows higher volatility, and beta less than one shows a less volatile and more stable asset.

For the finance person, these are amazing tools to determine risk and aid an effective decision-making process.

Written by Lawretta Egba.