Risky risk factors for your investments

The following post was sponsored by Sungard APT.

The typical retail investor will normally prefer to invest through mutual funds or exchange traded funds.  In Modern Portfolio Theory, there are several risk factors that will determine how the fund’s performance measures up against broad or narrow market benchmarks.  Investors would be well served to have at least a passing familiarity with terms like alpha, beta, and R-Squared.

Alpha

Alpha is a risk-adjusted measure of the performance of an investment. Taking the volatility, or price risk, of a security and comparing this to a benchmark index gives you the ‘alpha’.

In simple terms it is what has been added or lost from your investment’s return: a positive alpha of 1.0 means it has outperformed its benchmark index by 1%.   In even simpler terms, it means not so much if your investments has delivered respectable annual returns of 7%, if the investment is in high-risk assets like Peruvian alpaca wool futures or Greek bonds.

Volatility of the Dow Jones Industrial Average Index since 1928, impact of the 30th, of 1987. (Photo credit: Wikipedia)

Beta

The ‘beta’ is a measure of the volatility, or systematic risk, of a security in comparison to the market as a whole. It is calculated using regression analysis, and can be considered simply as the tendency of an investment’s return to respond to swings in the market.

The market itself has a beta of 1.0 and securities with a lower beta are less volatile than the market. Conversely, equities with a higher beta than are more volatile than the general market.  Biotech or software stocks, for example, tend to feature high beta scores (and high price to earnings ratios to match), while more sedate, mature stocks like Wal-Mart or utilities like Duke Energy, both with a beta of 0.32, offer lower risk and dividends to boot.

Beta is a common enough metric, and prominently featured on many finance sites like Google and Yahoo!.

R-Squared

R-Squared isn’t as common.  It is a statistical measure that is used to represent the percentage of a security’s movements that can be explained by movements in a benchmark index. R-Squared values range from 0 to 100 and generally speaking those with a value above 85 can be expected to perform similarly to the index.  A value below 40 means that the fund doesn’t move in lockstep to index.  We could think as R-Squared of validation for the fund’s beta value.

Alpha, beta and R-squared are metrics related to Modern Portfolio Theory (MPT), and commonly referred to as MPT Statistics

Standard deviation

Standard deviation is a statistical term for the spread or dispersion of data from its mean. Standard deviation is used for investments to measure its volatility or risk. It can indicate how much a return on an investment is deviating from its historical performance. A volatile stock naturally has a high standard deviation.

Sharpe ratio

Sharpe ratio measures the risk-adjusted performance of an investment by subtracting the risk-free rate of return (e.g. a government bond) from the rate of return for an investment and dividing this by the investment’s standard deviation of its return.

This useful formula can be used to tell you whether an investment’s returns are due to smart decisions or are the result of excessive risk. This is particularly useful in pulling out of investments that reap high returns but expose you to great risk.

In conclusion…

Regardless of how many investments you have, managing risk has never been more important. In today’s volatile economic climate a survey of large investment businesses – details of which can be found at SunGard.com/APT – found that 85% of those surveyed felt that risk will play an increasingly important role in their organisations, and 80% agreed that risk management was central to the raising of assets.

By clicking here you can discover the range of sophisticated risk indicators that SunGard APT uses to analyse its clients’ portfolios, but in this article you will find out exactly what the five most frequently used risk indicators actually mean for you.