How Is Investment Risk Measured? - YouTube

Hello I’m Dieter Scherer, fee-only financial planner and founder of

RealizeYourRetirement.com.

This video is part of a series called Foundational Finance,

where we’ll go over the basics you need to know to get up and running in investing

and begin to speak the language of finance.

Foundational Finance is a part Retirement Planning Academy,

a free course I offer on RealizeYourRetirement.com.

Today’s video covers how we measure risk in finance.

Despite what some financial pundits and advisors may say,

risk can’t really be distilled into a single number, so we use multiple measures to illustrate the potential risk of a strategy.

So how is risk measured?

Well, the way we measure risk may change depending upon our own circumstances and goals.

For retirees it’s needing a constant stream of income, but market fluctuations that cause you to sell when

the market is down.

Whereas, Younger investors can hold on to their investments for a very long time before they need to sell

them to produce income, so they can generally weather higher fluctuations in their portfolio’s value.

When you’re investing in individual stocks the risk is the chance

that a stock will have a permanent loss that does not recover.

So with each of these there we may want to look at a different aspect of risk.

While there are numerous ways to measure risk,

I’m going to focus on the six most important measures that you ought to know.

These are volatility,

downside volatility,

max drawdown, max drawdown sum,

the sharpe ratio,

and the sortino ratio.

I’ll explain and provide an example for each of these in turn.

First up is volatility, which is another word for fluctuations.

Volatility is measured by a statistical method called standard deviation.

Standard deviation measures how much your returns fluctuate

around the average historical return you might see reported.

This is the measure

of risk that you are most likely to see reported by almost every financial organization or advisor

and is what many people directly equate to risk.

Basically, the higher the standard deviation,

the more an asset is likely to fluctuate in value ,

and therefore the volatility risk is higher.

Standard deviation counts both upward movements and downward movements

of an investment as risk,

not just downward movements as one might expect.

Let’s dig into an example to better illustrate this.

So here we’re looking at the price graph of a fictional stock.

As you can see, it increases and decreases through time.

We measure these upward and downward movements in the form of

percent increases and decreases.

So let’s look at the percent returns of this example stock and how we measure its volatility.

So here we have the percent returns of the same example stock we just saw.

The average return per period is 8%,

which is demonstrated with the yellow line.

While the average return is 8%, as you can see each year the returns vary greatly from 8%.

In year 2 the stock is up around 60%,

then it’s down down 19%,

then up 38%

then down 33%,

then up 58%

and then up and down various amounts.

So even though the average return is 8%, the standard deviation,

or how much it varies away from the average,

is extremely high at 34%.

It would require a statistics course to delve into

exactly what the 34% represents,

but you should use this number relative to other standard deviations.

If you compare this to stock B with a standard deviation of 10%,

we’d expect stock B to have less wild fluctuations.

So the greater the number, the larger the fluctuation will be around the average.

Now these are a bit exaggerated so that it’s easier to see them on the graph,

but the idea remains the same when you measure any stock or bond’s volatility.

The interesting thing with standard deviation though is that it measures both upside AND downside fluctuations.

Most people don’t really mind when their investment increases in value,

so we can modify standard deviation to just measure the downside movements

below a certain rate.

We could pick any rate, whether it be 0%,

5%, or if it’s lower than a risk-free asset like Treasury bills.

Looking at just how much it moves on the downside is

much more representative of how investors think about risk.

Again we have the same example stock with the same price movements.

Then here we have the percent returns with an average of 8%,

but this time we’re only going to look at them below a certain rate.

Most people require at least a 5% return to meet their retirement needs,

so let’s use that as our target rate.

If we look at how often the returns dip below 5%,

we can see how much things fluctuate on the downside,

which is what most investors think about when they think of risk.

So this stock had a volatility of 34%,

but if we break it down into it’s component parts,

we can have a better picture.

So when we calculate downside volatility here,

we see it has a downside volatility of 13%,

meaning a large portion of the volatility came from upward movements

and a smaller portion from downward.

So if we compare both volatility and downside volatility

to another stock or bond,

we’ll have a better picture of how wildly the stock

will fluctuate and in which direction.

Again the higher the downside volatility the higher the risk,

the lower the downside volatility the lower the risk.

The next risk measure we’ll look at is Max Drawdown.

Now max drawdown is a little more intuitive than volatility.

Essentially, it’s the percent difference between the highest value the account has ever been and the lowest the account has been.

This enables us to see what the worst case scenarios in the past have been.

It’s easy to compare two strategies and say,

OK, we have a loss of 15% and a loss of 55%.

Obviously a worst case scenario loss of

15% is better than a worst case scenario loss of 55%.

Let’s see what this looks like on the graph.

Again we have the same example stock.

But this time we are going to be looking at loss from the highest high so far to the

lowest low so far.

So here we have the returns once again and we can see that there are several periods of losses.

The first period is during year 3 and is highlighted in orange.

It’s an 19% loss, so that the maximum the stock has fallen so far, so

our max drawdown is 19%.

Well in between years 4 and 5, there is another period of loss.

This time the total loss is 33%.

Well’ 33% is a bigger loss than 19%, so our max drawdown is now 33%.

Finally the last major loss period between years 8 and 9 has a loss of 36%.

Well 36% is a bigger loss than 33% so our max drawdown is 36%.

The last period by year 11 obviously has a much smaller loss that won’t exceed the 36% loss,

so our max drawdown remains at 36%.

So, max drawdown gives us a single number that tells us the single largest loss that the stock or portfolio has endured.

But it only tells us what the single biggest loss was.

Now, to see other losses, we could of course look at the

second largest, third largest loss and so on.

But that’s very time consuming.

Instead, we can come up with a better way to gauge the size of portfolio losses through time.

If we extend the idea of max drawdown we come up with the idea of adding all of the drawdowns our portfolio experiences

through time, adding up every loss compared to the highest value at that time.

When we add them all up we can tell if the portfolio only had one large loss,

And in that case the sum of all of the losses would be small,

Or if the portfolio has consistently large losses,

we would come up with a much bigger number.

We’d be able to see that a large loss in the portfolio wasn’t a fluke,

but consistently occurs.

So it allows us to compare the frequency and size of losses across portfolios.

So in graph form we would look at all of the times that the portfolio has a negative return,

which are highlighted in orange on the graph.

First there was the 19% loss,

then the 33% loss,

then the 36% loss

and finally the 13% loss.

When we add all of them up,

remember they are losses so they are negative,

we get -101%.

In isolation this number tells us some details,

but it’s best used in comparison to other portfolios.

For example, a portfolio with frequent small losses

and a small max drawdown might have a larger max drawdown sum

than a portfolio that has one really big max drawdown

and very few other losses.

The Sharpe Ratio, named after William Sharpe,

allows us to see how much return we are

going to receive by the amount of risk we’re taking on.

First, it uses volatility, also known as standard deviation, to approximate risk.

And here’s the formula.

If you aren’t a math geek that’s OK,

it’s actually pretty straightforward.

All it’s saying is that we’ll take the average return of the portfolio

and subtract out the return we could have gotten by putting our money in a

bank account or really short term Treasury Bills,

and then we’re going to divide the answer to that by the amount of volatility.

Basically, this helps answer the question,

how much return can I expect for each amount of additional risk I’m taking on.

The higher the Sharpe ratio the better because a higher sharpe ratio means that you are receiving

more reward for the amount of risk you are taking on.

A modification of the Sharpe ratio is known as the Sortino ratio,

and it’s named after Frank Sortino.

The Sortino Ratio uses downside volatility instead of volatility like the

Sharpe ratio.

And instead of using the risk-free rate, it uses whatever target rate you’d like to measure it against.

Most people use a target rate of 5% returns for both the downside volatility measurement and the target rate.

So this ratio answers the question how much return can I expect per unit of downside risk.

Most people only care about downside risk

so this can be a more helpful ratio when trying to determine potential

downsides of the investment.

Again, you want higher Sortino ratios.

OK, let’s do an example.

Here are two completely hypothetical portfolios

I’ve put together to illustrate how you’d use all of these tools to

evaluate two different investments.

First we’d look at the returns and see that they are both 8%, ok fair enough,

now let’s look at the risk measures.

Well we see that the volatility risk of A is 15%,

which is greater than the 10% of Portfolio B,

so A will likely fluctuate a bit more.

If we then look at downside volatility we can see that portfolio A,

with a downside volatility of 11%,

is far more risky than portfolio B,

with a downside volatility of 6.5%.

Now if we look at the max drawdowns we see something interesting.

Everything has been telling us that portfolio A is more risky than portfolio B,

but portfolio B has a larger max drawdown of 40%,

than portfolio A which only has a max drawdown of 20%.

If we look at this in isolation we may go back on our previous conclusion

and now think that portfolio B looks scarier,

but we’re not done just yet.

So that brings us to max drawdown sum and here we get the rest of the story about losses.

While portfolio A has a smaller maximum drawdown of 20%,

it seem to more consistently have losses in the portfolio,

whereas portfolio B seems to have had one big loss and then had smaller losses the rest of the

time. So the one big loss may only occur under certain circumstances.

Next up is the Sharpe ratio, which tells us how much we’re rewarded for volatility risk.

With a risk free rate of 3% we see that the edge goes to portfolio B

because it offers the same return at lower volatilities.

Finally we have the sortino ratio with a target return of 5%.

Here we see that portfolio B offers us greater rewards for the amount of downside risk,

in facti t’s almost twice as much per for each unit of downside risk we take on.

So, portfolio B is better on most measures but you better watch out if those circumstances that

caused it to lose 40% align once again.

As you can see each of these measures helps us look at a different aspect of risk for

each of the portfolios and better grasp who a portfolio might be better for.

If you had just looked at the Return and Volatility you wouldn’t have had the full picture.

So, I’ve shown you some of the more useful risk measures that you can use to evaluate a portfolio,

however, most of the time you’ll just see volatility and maybe the sharpe ratio.

Unfortunately, as I’ve mentioned those don’t look at enough aspects of risk to be

used in isolation, so you have two choices.

You can either calculate each of these yourself

or you can request your advisor to do so for you.

I’ll include some example calculations in an excel sheet in the members section for those of you who’d like to calculate

If you’d like to learn more about the basics of finance, watch these other videos in the Foundational Finance series.

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