16/12/2019 Common Methods for Measuring Risk in Investments

TRADING SKILLS & ESSENTIALS RISK MANAGEMENT

Common Methods of Measurement for

Investment Risk Management

BY TROY SEGAL | Updated Mar 25, 2019

Risk management is a crucial process used to make investment decisions. The process
involves identifying and analyzing the amount of risk involved in an investment, and either
accepting that risk or mitigating it. Some common measures of risk include standard
deviation, beta, value at risk (VaR), and conditional value at risk (CVaR).

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Standard Deviation
Standard deviation measures the dispersion of data from its expected value. The standard
deviation is used in making an investment decision to measure the amount of historical
volatility associated with an investment relative to its annual rate of return. It indicates how
much the current return is deviating from its expected historical normal returns. For
example, a stock that has high standard deviation experiences higher volatility, and
therefore, a higher level of risk is associated with the stock.

Beta

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Beta is another common measure of risk. Beta measures the amount of systematic risk an
individual security or an industrial sector has relative to the whole stock market. The market
has a beta of 1, and it can be used to gauge the risk of a security. If a security's beta is equal
to 1, the security's price moves in time step with the market. A security with a beta greater
than 1 indicates that it is more volatile than the market.

Conversely, if a security's beta is less than 1, it indicates that the security is less volatile than
the market. For example, suppose a security's beta is 1.5. In theory, the security is 50 percent
more volatile than the market.

Value at Risk (VaR)

Value at Risk (VaR) is a statistical measure used to assess the level of risk associated with a
portfolio or company. The VaR measures the maximum potential loss with a degree of
confidence for a specified period. For example, suppose a portfolio of investments has a
one-year 10 percent VaR of $5 million. Therefore, the portfolio has a 10 percent chance of
losing more than $5 million over a one-year period.

Conditional Value at Risk (CVaR)

Conditional value at risk (CVaR) is another risk measure used to assess the tail risk of an
investment. Used as an extension to the VaR, the CVaR assesses the likelihood, with a certain
degree of confidence, that there will be a break in the VaR; it seeks to assess what happens to
investment beyond its maximum loss threshold. This measure is more sensitive to events
that happen in the tail end of a distribution—the tail risk. For example, suppose a risk
manager believes the average loss on an investment is $10 million for the worst one percent
of possible outcomes for a portfolio. Therefore, the CVaR, or expected shortfall, is $10 million
for the one percent tail.

Categories of Risk Management

Beyond the particular measures, risk management is divided into two broad categories:
systematic and unsystematic risk.
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Systematic Risk
Systematic risk is associated with the market. This risk affects the overall market of the
security. It is unpredictable and undiversifiable; however, the risk can be mitigated through
hedging. For example, political upheaval is a systematic risk that can affect multiple financial
markets, such as the bond, stock, and currency markets. An investor can hedge against this
sort of risk by buying put options in the market itself.

Unsystematic Risk
The second category of risk, unsystematic risk, is associated with a company or sector. It is
also known as diversifiable risk and can be mitigated through asset diversification. This risk
is only inherent to a specific stock or industry. If an investor buys an oil stock, he assumes
the risk associated with both the oil industry and the company itself.

For example, suppose an investor is invested in an oil company, and he believes the falling
price of oil affects the company. The investor may look to take the opposite side of, or hedge,
his position by buying a put option on crude oil or on the company, or he may look to
mitigate the risk through diversification by buying stock in retail or airline companies. He
mitigates some of the risk if he takes these routes to protect his exposure to the oil industry.
If he is not concerned with risk management, the company's stock and oil price could drop
significantly, and he could lose his entire investment, severely impacting his portfolio.

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Related Terms
Conditional Value at Risk (CVaR)
Conditional Value at Risk (CVaR) quantifies the potential extreme losses in the tail of a distribution of
possible returns. more

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Systematic Risk Definition

Systematic risk, also known as market risk, is risk inherent to the entire market or market segment.
more

Risk Management in Finance

In the financial world, risk management is the process of identification, analysis and acceptance or
mitigation of uncertainty in investment decisions. Risk management occurs anytime an investor or
fund manager analyzes and attempts to quantify the potential for losses in an investment. more

Risk
Risk takes on many forms but is broadly categorized as the chance an outcome or investment's actual
return will differ from the expected outcome or return. more

Market Risk Definition

Market risk is the possibility of an investor experiencing losses due to factors that affect the overall
performance of the financial markets. more

Understanding Beta and How to Calculate It

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the
market as a whole. Beta is used in the capital asset pricing model (CAPM). more

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