Investment risk is the probability that the investment will perform below the expectation. Therefore, it is the probability that the actual return from the investment will deviate from the expected (average) return. So, this article explains the strategies to measure and manage your investment risk.
Types of Investment risk
Risk can be divided into two broad categories as follows:
This is a market risk that affects the general market. It is a non-diversifiable risk. So, the risk is very hard to manage because it is inherent. Examples of systematic risk include Political instability, changes in economic conditions, Government policy, war, natural disasters, and others.
This is a specific and diversifiable risk that affects only a company or a sector. So, investors can manage this risk through diversification. This is only peculiar to a particular company or industry, it doesn’t affect all the companies in the industry or all industries in the market. Examples of unsystematic risk include bad management, labor strike, and others.
Strategies to measure and manage investment risks
It is important to measure and manage the risk because it is crucial to the investment decision. So, investors must be able to identify and analyze that risk attach to investment to determine whether to mitigate or accept the risk. However, the strategies to measure and manage risk include the following:
This measures the dispersion of investment’s return from the longer-term average return. It measures the rate of the volatility of the investment from the annual rate of return. Therefore, standard deviation looks at how actual return deviates from the expected historical returns. However, the higher the standard deviation of security, the higher the volatility, so the higher the risk.
Beta measures the relative volatility of a security or an industry to the whole market. Every market has a beta of 1.00. So, any security with a beta above 1.00 is very volatile than the market, therefore, it is risky. While any security with a beta below 1.00 is less volatile compare to the market, therefore, it is less risky. However, security with exactly 1.00 means that its price is moving in line with the market.
This measures the performance of the active management by measuring the excess return of a particular security or portfolio of a benchmark index. Therefore, alpha measures the performance of a particular security or portfolio instead of the general market. So, it calculates the excess return over the expectations of the market.
This ratio measures the extent to which return from an investment rewards the investors consider the level of risk taken. The ratio has a direct relationship with the return. For example, if the ratio is 3, it shows that 3 units of return for a unit of risk taken. So, if the ratio is positives, it is gain, while if the ratio is negative, it is loss. Therefore, the higher the Sharpe ratio, the better the risk-adjusted performance is. This ratio is calculated by deducting the rate of return of a risk-free investment from the expected rate of return, then divide it by the standard deviation of the investment.
R-squared measures the performance of the fund by calculating the percentage of the fund’s movements in correlation with a benchmark index. Meanwhile, the range of R-squared is between 0 to 100. The closer the R2 is to 0, the lesser the fund’s return. Therefore, an investor can pay higher fees for professional management. Investors should avoid funds with a very high R2 ratio, they are regarded by analysts as closet index funds. However, the benchmark for bond and fixed income securities is the U.S. Treasury bill, while S&P 500 Index is for equities.
Value at Risk (VaR)
VaR measures the level of risk attached to a firm or portfolio by calculating the likelihood that future losses will remain within a particular range. So, it measures maximum potential loss to incur in a particular period with a certain degree of confidence. For instance, if a portfolio has a one-year 5% VaR of $10,000. So, it means that the portfolio has a 5% probability of losing more than $10,000 over a year.
In conclusion, measuring the investment risk is very vital to the investment decision. It is better to use a variety of risk measurement methods to have a clear picture of the risk than to use only one method. However, you may need professional advice from your financial advisor to select the methods that will meet your needs and goals.
Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.