Compounding offers the opportunity to help you build wealth, or, if you’re not careful, can lead to significant financial problems.
You Know Risk and Volatility, But Can You Measure Them?
Risk means different things to different people. Someone with high risk tolerance might be entirely comfortable with a large exposure to the stock market and the volatility that comes with it, even as retirement years approach. Those who are more risk averse might want a nice smooth, low-risk ride for decades.
But it might not do you much good to know your risk level if you can’t measure it. How do you know if a particular stock is riskier than others? How do you know if your portfolio might be subject to large, unsettling swings?
Using Asset Allocation as Broad Measure
Broadly, you can measure risk based on your asset allocation. In general, the higher exposure you have to equities (whether it’s through individual stocks, ETFs or mutual funds), the more risk you may be taking. But there can be a wide difference in risk among individual stocks, or even broad-based funds like ETFs. Here are a few ways to measure risk.
What Beta Can Tell You
Beta measures the volatility of a security compared to the market (usually the S&P 500). In theory, a security with a beta of 1 would have the same volatility as the overall market – meaning it would rise or fall in the same percentage as the market.
A beta of 1.2 means a security is 20 percent more volatile than the overall market. So a $1 move up or down in the market would equate to a $1.20 move in the security. Conversely, a beta of 0.8 means a security is 20 percent less volatile than the rest of the market.
Cash is considered to have a beta of zero – which makes sense because any move in the market will have no impact on your cash.
What Standard Deviation Says
Another common measure is standard deviation, which measures the historical percentage change in a security. Standard deviation measures the risk of the security itself, rather than comparing that security to the market, as beta does.
Standard deviation is based on a statistical model; in general, the higher the standard deviation, the greater the risk. Here’s how it works:
Let’s say you own a stock with a standard deviation of 2 percent, and an average annual return of 7 percent. The standard deviation model says that about 70 percent of the time you can expect an annual return within one standard deviation (or 2 percentage points, up or down) of the average return, or a range of 5 to 9 percent. And 95 percent of the time, you can expect returns to be within two standard deviations (or 4 percentage points) from the average, which is a range of 3 to 11 percent.
Many stocks have much larger standard deviations than 2, so don’t get too caught up in the numbers above. Just know that a stock with a standard deviation of 15 percent would be considered to be far riskier than one with a standard deviation of 3 percent.
The Sharpe ratio uses a mathematical formula (which includes standard deviation) to show a security’s expected return relative to its risk. The higher the Sharpe ratio, the higher the assumed return for the risk being taken. Sharpe ratios can be used to compare similar or different assets to each other. The Sharpe ratio doesn’t tell you whether a particular security has high or low volatility, only whether you’re being compensated for the risk you’re taking.
From Measures to Action
Beta, standard deviation and Sharpe ratio can be used when you’re rebalancing or adding to your investment portfolio. Understanding these measures can help you determine whether any securities you’re considering fit with your investment strategies and risk tolerance. But you should also be aware that none of these measures is foolproof, and you should use them as a guide rather than a definitive predictor of future risk.
Question: Have you figured out either the beta or the standard deviation of securities in your portfolio?
Next Step: Scottrade clients can find beta and standard deviation for stocks, exchange-traded funds and mutual funds by logging in and going to the Quotes & Research section. For stocks, standard deviation is called “Volatility Avg” and you can find it (and beta) on the summary page when you research a stock. For mutual funds and ETFs, beta, standard deviation and Sharpe ratio measures can be found when you research a fund by clicking on the Morningstar® report on the lower right.
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