While all investors want to generate the best possible return on their capital, attitudes to risks vary greatly and so many choose to temper return expectations in favour of more stable earnings. One of the more significant defining factors of portfolio management is finding the most appropriate balance between risk and reward.
Thankfully, the increasingly quantitative approach to investing – accompanied by the rise of
and other factor-based strategies – means investors now have a range of financial tools at their disposal to help make capital allocation decisions based on their individual risk profiles.
Most of these ratios analyse the performance of funds against a standard benchmark index, such as the S&P 500 basket of large US stocks, or against a risk-free investment – including a government bond.
Also referred to as the ‘abnormal rate of return’ or ‘active return’, alpha provides a measure of an investment’s performance relative to benchmark funds. Based to zero, a positive alpha implies that a fund generated returns better than its benchmark over a certain period, while a negative number points to underperformance relative to the market. For example, an alpha value of one indicates that an investment’s return over a certain period was 1% higher than the benchmark’s.
Beta measures how volatile a stock or fund is relative to the market – or an asset’s sensitivity to market movements. Beta is based at one, where one infers that a fund performed exactly in line with its benchmark. A beta reading of less than one suggests that a fund is less volatile than its benchmark. This could be because the fund has exposure to money market investments, for example (this dilutes its equity market exposure). On the other hand, a beta value of more than one means a fund is historically more volatile than its benchmark. This could suit a high-risk investor, who would stand to gain when volatility is to the upside.
A measure of an investment’s risk-adjusted performance which aims to show whether returns are based on solid investment strategies or just excessive risk. The Sharpe ratio is calculated by removing the risk-free rate of return from total return, and dividing this figure by the standard deviation of an investment. A high Sharpe ratio indicates a solid risk-adjusted performance, or healthy returns generated without the use of excessive risk: the sign of quality equity funds. A common alternative to the Sharpe ratio is the information ratio, which is easier to calculate as it does not include the risk-free rate of return.
To measure volatility, or the risk associated with a fund’s holdings, an investor can analyse the standard deviation rating of an investment, which shows how much the investment tends to drift from its average returns. If returns data is spread far apart, it means a fund or portfolio has a high standard deviation or volatility rating. A low standard deviation indicates more stable returns.
These widely-used financial risk ratios help investors compile well-balanced, quality portfolios that seek to
boost returns while simultaneously managing risks.
and beta need to be compared alongside one another in order to find the most appropriate balance between returns and risk management across a portfolio.