Measuring risk – Part 3

Beta

A better method of measuring risk is referred to as beta. Beta measures an individual investment’s volatility in relation to the stock market in general, as measured by the Standard & Poor’s 500 Stock Index (S&P 500). The S&P 500 has a beta of 1. A security whose value goes up and down 25 percent less than the S&P 500 has a beta of 0.75; in other words, it has historically had less volatility than the market as a whole. A security whose value goes up and down 25 percent more than the S&P 500 has a beta of 1.25, meaning it has typically been more volatile than the overall market.

This measurement is also useful because it suggests how far you can anticipate your investment might fall when the market falls, and, conversely, how much your investment may rise when the market rises. Be aware, however, that beta measures market risk only, not an investment’s or investment portfolio’s total risk.

Alpha

Alpha measures an investment’s beta against its actual performance. A positive or high alpha implies that the investment has outperformed the market, whereas a negative or low alpha implies the opposite.

Say that this year U.S. savings bonds returned 6 percent, the S&P 500 returned 10 percent, and your investment returned 12 percent. Your investment’s beta is 1.2 (see above). You would ordinarily expect that your investment would yield at least as much as the U.S. savings bonds. However, the market (S&P 500) returned 4 percent more than the bonds (10% - 6%). Therefore, you should expect your investment to yield 6 percent (bonds), plus its beta (1.2) times 4 percent (the extra return), which is 10.8 percent [6% (1.2 x 4%)]. Your investment, though, actually earned 12 percent, which is 1.2 percent more than you expected (12% - 10.8%). Your investment’s alpha, then, is 1.2. Had your investment returned only 6 percent, it would have an alpha of -4.8.

Treynor index

The Treynor index measures the excess return per unit of risk taken. The higher the Treynor index, the more return the investment is making per unit of risk it is taking.

Style analysis

Style analysis is a statistical method that identifies how a mutual fund performs compared to individual global asset classes. Broadly defined, global asset classes include large cap stocks, small cap stocks, foreign stocks, emerging market stocks, domestic bonds, international bonds, and cash. Values, called factors, are used to represent how closely a fund’s performance matches the performance of indexes representing the different global asset classes.

R-squared

R-squared is a measure of a mutual fund’s diversification relative to the market. You can use R-squared to evaluate how likely a fund’s return is to resemble the return of a given index; the higher the R-squared number, the greater the correlation between the two.

Article courtesy of Forefield.Securities offered through NPB Financial Group, LLC. A Registered Investment Advisor/Broker-Dealer Member FINRA, MSRB, and SIPC