Why you don’t need to learn Greek to understand investment risk
The measures of investment risk — like alpha, beta, standard deviation and R-squared—are not as complex as they might sound. A quick grasp of the concepts can be beneficial for all investors.
Virtually every decision in life, love, business and investing involves weighing risks against potential benefits. “The biggest risk of all is not taking one,” remarked Ariel Investments co-CEO Mellody Hobson, a passionate advocate for financial literacy and investor education.
The trouble is, without a proper appreciation of the risks involved, many people lack the confidence to invest. That is perhaps why, as revealed in research by CFA Institute, Gen Zers aged 18–25 who invest are twice as likely to have formal education about financial topics or investing than their non-investor counterparts.
To make it easier to quantify and monitor risk, the investment industry has developed several common measures. These often have intimidating, technical-sounding names based on statistical terminology or letters of the Greek alphabet. But the concepts they convey are quite straightforward. Investors would benefit from getting comfortable with them.
Because it is nearly impossible to directly measure risk – or even to pin down all the different risks related to an investment – the risk measures are technically proxies for risk. They are calculated using historical data and generally provide an expectation of how far an investment’s performance could deviate from an expected return or benchmark.
Greater investment risk is typically accompanied by the potential for greater returns. Investors need to consider their individual circumstances and risk appetite to determine how much risk they are willing to accept in pursuit of a given return.
Common risk measures
- Standard Deviation: One of the most common risk measures used by analysts, portfolio managers and wealth advisors and is an indicator of volatility. This is calculated using the historical price movements of an investment asset, and shows how far the price varies from its average level. The higher the standard deviation, the greater the potential deviation on both the upside and downside from the expected return, which translates to higher risk as well as potentially higher returns..
- Alpha: An indicator of how well a stock or fund has historically performed against a benchmark index, such as the S&P 500. Alpha values are typically used to rank the performance of actively managed funds.
But there are two things to watch out for when using alpha to compare investments. First, what is the time horizon? The longer the timeframe, the more likely it is to indicate true alpha since markets are usually more random in the short run. And second, is the benchmark appropriate? For instance, a fund might measure itself against the S&P 500, even though it is actually invested heavily in small-cap value stocks. - Beta: Measures the volatility of an investment against a benchmark index. A beta over one indicates that when the index rises or falls, the stock or fund would rise or fall by a larger percentage. A negative beta means the investment moves in the opposite direction of the index.
Beta is a sensitivity measure, quantifying how an investment moves in relation to a single risk factor. It is especially appropriate for stocks, where movements in the overall market are a big driver of price performance — especially over a shorter time horizon. For bonds, it is interest rate changes, which are captured by a sensitivity measure known as duration — the weighted average time it takes to receive all coupon and principal payments. Bonds with a higher duration are typically more sensitive to changes in interest rates.
There are also several sensitivity measures related to options, known as the “Greeks” (see below).
R-squared, sharpe ratio and value at risk
Other widely used risk measures include R-squared, the Sharpe Ratio and Value at Risk.
- R-squared: Provides a measure of how much an investment’s performance is determined by movements in the benchmark, rather than random variation. It is commonly stated as a percentage from 0% to 100%, gauging how reliably alpha and beta capture the relationship between changes in the investment and overall market.
- Sharpe Ratio: Calculated by first determining an investment’s expected return above the risk-free rate of return typically denoted by the interest rate on a 10-year US Treasury Bond. This is then divided by the risk needed to pursue that return, as measured by standard deviation. Sharpe ratios can be used to compare investments on a risk-adjusted basis.
- Value at Risk (VaR): Quantifies the extent of possible financial losses over a specified timeframe at a pre-defined confidence level. For instance, a given investment might have a maximum expected loss of USD1 million over a one-month horizon with 95% confidence. VaR is a straightforward concept that can be used to compare risks across asset classes, portfolios and trading units. However, it has its limitations, including its subjectivity resulting from numerous discretionary choices that are made in the course of its computation.
The options greeks
There are four primary risk measures associated with options trading, known as the Greeks: delta, gamma, theta and vega. These indicate how an option’s price moves in relation to various indicators.
- Delta: Represents the relation between the rates of change of the option’s price and that of the underlying asset.
- Theta: Reflects how quickly an option’s price will decrease as it approaches its expiration.
- Gamma: Reflects a second-order price sensitivity, comparing the rate of change of an option’s delta and the underlying asset’s price.
- Vega: Indicates the change in an option’s price for a change in volatility of the underlying asset.
Notably, the value associated with each of these Greeks changes over time, as the option approaches expiry. Options traders may calculate these values daily to determine whether they need to adjust their positions.
Compare, contrast and hedge
These risk measures can be used individually or in combination to compare potential investments. They can also be used to inform strategies to mitigate risk, through methods such as hedging and diversification.
Investors, for instance, might look to lower-beta stocks when markets are volatile. Stock options also allow investors to hedge against a particular measure, such as taking a delta-neutral position where any small decline in the stock’s value is made up for by gains from the value of options.
Driving better investment decisions
Identifying and measuring investment risk helps avoid some of the most common investment mistakes, such as not having clear investment goals, trading too frequently, trying to time the market, and taking on too much risk – or too little.
An investor whose strategy is formulated on the basis of careful consideration of objective measures of risk will likely have an easier time sticking with their strategies. The discipline to looking beyond market cycles and stick to an investment approach is the hallmark of all legendary investors who have consistently outperformed the market, like Warren Buffett, George Soros or Ray Dalio.
Financial literacy and developing a systematic understanding of the risks involved can play a big part in developing the risk tolerance needed to invest effectively. Investors who do not get comfortable with these concepts may struggle to achieve their long-term financial goals.
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