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Recognizing, measuring and determining investment risks

June 18, 2020

reading time: 5 minutes

by André Schmidt-Carré, guest author

Risikomasse

The same rule applies for every investment: no returns can be generated without a certain amount of risk. Investors must therefore carefully consider the risks they take.

Strong price fluctuations, such as those seen during the COVID-19 pandemic, are a clear reminder that investing money always entails  risk. As a general rule, greater opportunities for returns go hand in hand with higher risks. A number of different key figures and metrics can help investors to steer risk and return. Here is an overview:

Ratings

Investors who want to assess the risk of a bond can use ratings to do so. Independent rating agencies such as Standard & Poor’s or Moody’s assess the quality of corporate bonds, for example, according to a comprehensive set of criteria: they check balance sheets, talk to managers, analyze markets and assess the competitive as well as the political and legal situation. This information is then used to rate the creditworthiness of companies or bonds. A letter-based rating system ranging from AAA (the highest rating) to D (the lowest rating), has been established to this end. It indicates the default risk that investors bear when they invest in a particular bond.

Volatility

Volatility is a fundamental risk measure that reflects how much the value of an investment fluctuates over time and is measured as a percentage. More specifically, volatility expresses the extent to which a price deviates on average from its mean price in either an upward or downward direction. Looking at the price of an investment product over time as a curve also shows its volatility: lines without any spikes have zero volatility. They always stay on course because there is no change in their price. The greater the spikes in a curve, the higher the volatility. 

Investment professionals distinguish between historical and implied volatility. Historical volatility shows an investment’s average up and down movement in the past. It is calculated based on the price fluctuations that have occurred. Implicit volatility, on the other hand, looks ahead and estimates the price fluctuations expected in the future. The calculations are based on data relating to supply and demand on futures markets, where traders enter into future transactions. 

Accepting high volatility
Accepting high volatility

So why make investments that are subject to high volatility? Because they generally offer opportunities for higher returns. The following should therefore be kept in mind: the longer an investor’s investment horizon, the more likely they are to accept an investment’s price fluctuations associated with volatility. This is because if they have a long-term horizon, they will not be forced to sell the investment after a fall in price.

Maximum Drawdown

Another metric that investors can use to better understand the risks involved when investing is the so-called maximum drawdown. Like volatility, this is expressed as a percentage. However, it does not quantify the extent of price fluctuations, but rather the largest loss that an investment product has experienced within a specific period of time in the past. This figure expresses what many investors commonly understand as risk.

Sharpe Ratio

The Sharpe ratio is one of the most important risk measures in the world of finance: it indicates the excess return that can be achieved with a risky investment versus a safe investment by comparing the expected excess return with the volatility. It thus measures an investment’s risk/return ratio. In other words, it quantifies the degree to which an investor is rewarded for investing money in an investment that entails a certain amount of risk instead of making a safe investment.

This risk measure was named after the Nobel Prize winner, William F. Sharpe, who developed it. One of the great advantages of the Sharpe ratio is that it makes it possible to compare different investments, be they shares or complex investment funds. If, for example, two investment funds had comparable returns in the past, the fund that achieved this return with a lower level of risk will have a higher Sharpe ratio.

Now things get really interesting

Professionals use many other measures to assess risk. Many of these are quite complex and abstract, meaning that they are not of much use to laypersons who are unfamiliar with them. But they show how other investors try to assess the volatile nature of markets.

One of these risk measures applied by more advanced investors is the information ratio. It is used to assess whether making an investment that deviates from a benchmark index will pay off. Active fund managers use it to demonstrate the returns they have generated with their investment decisions compared to the benchmark index (e.g. the Dow Jones). The information ratio is considered to be a further development of the Sharpe ratio. It compares possible investment returns not with the return on the safe investment, but with that of the benchmark index.

Conclusion

When assessing risks, investors generally try to find the ideal balance between investment risk and the possibility to generate returns. Risk measures support them in this by helping to quantify risks and also providing greater transparency. Investors should not forget, however, that each measure focuses on a sub-segment of the investment process. In consultation with an investment expert, they should determine which risk measures are particularly suitable for assessing their individual investment risks.

Pictures: Shutterstock

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