How to Estimate Investment Risk?

You’ve probably heard the saying, “Nothing ventured, nothing gained.” While this holds true in financial markets, investors typically seek a middle ground. They aim for a level of investment risk they can tolerate while still achieving satisfactory potential returns. In this article, we’ll show you how to independently assess the risk of your investments and build portfolios that make risk your ally, not your enemy, in the long run.

Understanding Investment Risk

Let’s start with the basics. Investment risk is the probability that your actual investment returns will differ from expected results. You may also lose part or all of your initial investment. Risk is a fundamental market concept that you, as an investor, must grapple with because it directly impacts your portfolio’s performance and stability. Risk applies to all types of investments, from stocks and bonds to real estate and commodities, and even the simplest savings accounts in banks. A simple rule of thumb is that the less you can earn (the lower the rate of return), the lower the risk will be. As an investor, you’ll be exposed to various types of risk when investing your money in financial markets:

• Systematic risk: Also known as market risk. It includes factors such as economic downturns, political instability, or global pandemics.
• Unsystematic risk: This risk is specific to individual companies or industries. It may include changes in management, product recalls, or new competitors entering the market.
• Volatility risk: Refers to the ups and downs of investment value over time.
• Inflation risk: The risk that the purchasing power of investment gains will be reduced over time by inflation.
• Liquidity risk: The possibility that an investor won’t be able to buy or sell an investment quickly enough to prevent or minimize a loss. If you plan to invest, you won’t be able to eliminate risk entirely, as it’s an inherent part of financial markets. However, you can learn ways to estimate and measure it, as well as tools to manage it, to build a portfolio that matches your risk “appetite” or “aversion.”

4 Basic Methods for Estimating Investment Risk

To effectively estimate investment risk, it’s worth using several of the most popular and proven indicators used by investors worldwide. These are:

1. Standard Deviation
2. Beta
3. Sharpe Ratio
4. Value at Risk (VaR)

Standard Deviation

Standard deviation is a basic statistical measure that allows investors to determine the level of volatility of potential gains. It shows how much investment results may deviate from its average return over the studied period. A higher standard deviation indicates greater volatility and, consequently, higher risk for the investor. Standard deviation is calculated using a simple mathematical formula. As an investor, you should primarily know how to analyze standard deviation results. Interpreting standard deviation:

• Low standard deviation: More consistent returns, lower risk
• High standard deviation: More volatile returns, higher risk Let’s take the S&P 500 index as an example. Over the past 32 years, its compound annual growth rate was 10.98%, with a standard deviation of 15.24%. This means you can expect its performance to fall within the range of -4.26% to 26.22% two-thirds of the time.

Average annual return of the S&P 500 index over the past 32 years. Source: Curvo.eu

Beta

Beta is a measure of an investment’s volatility relative to the overall market. It indicates how much an asset’s price changes in response to market fluctuations. How Beta measures market risk:

• A beta coefficient of 1.0 indicates that the investment moves in line with the broad market.
• A beta coefficient greater than 1.0 suggests greater volatility than the market.
• A beta value less than 1.0 means less volatility than the market.

The S&P 500 would be the equivalent of the “broad market” to which individual stocks are compared. If we assume that Apple, a component of the index, has a Beta coefficient of 1.24, the interpretation would be as follows:

• Apple stock will rise by 12.4% if the broad S&P 500 market index gains 10%
• Apple stock will fall by 12.4% if the broad S&P 500 market index drops by 10%

Sharpe Ratio

The Sharpe ratio, named after Nobel laureate William Sharpe, is a tool for measuring risk-adjusted investment return. It compares the excess return above the risk-free rate with its standard deviation. The ratio helps investors determine whether investment returns result from smart decision-making or excessive risk-taking. A higher Sharpe ratio indicates better risk-adjusted performance. Interpreting the Sharpe ratio:

• A ratio of 1 or higher is generally considered very good
• The higher the ratio value, the higher the rate of return at a constant level of risk
• A negative ratio value means the investment is achieving a return lower than the risk-free rate The S&P 500 index we’ve been analyzing has achieved a Sharpe ratio 0.68 over the past 32 years. While this value is below 1, considering the long-term analysis period, it suggests “moderately good” investment efficiency relative to the risk taken, and the potential return outweighs the potential risk.

Value at Risk (VaR)

Value at Risk (VaR) is the last of the four basic risk estimation measures. It determines the potential loss of investment value over time for an assumed “confidence interval.” This interval is a statistical measure that will be a specific probability (usually 95%) of its final outcome in the case of investments. VaR answers the question: “What is the maximum loss (or maximum return) we can expect at X% confidence level over period Y?” How to use Value at Risk in risk estimation: VaR is usually expressed as a currency value or percentage of the entire portfolio. If for the S&P 500, the compound annual growth rate is 11%, and the assumed 95% confidence interval is from 6% to 16%, then with 95% certainty, the index will return between 6% and 16%. However, there’s a 5% chance it won’t fall within this range. Strengths and Weaknesses of Investment Risk Assessment Indicators: Here’s the translated table in US English:

Indicator	Strengths	Weaknesses
Standard Deviation	- Simple interpretation of volatility - Widely used - Easy to calculate	- Doesn’t distinguish between upside and downside volatility - Assumes normal distribution of returns - Doesn’t account for market correlation
Beta	- Measures systematic risk - Allows comparison of risk relative to the market - Accounts for correlation with benchmark	- Requires defining an appropriate benchmark - Doesn’t measure total risk - Can be unstable over time
Sharpe Ratio	- Considers risk-free rate - Allows comparison of investments with different risks - Measures excess return per unit of risk	- Sensitive to analysis period - May give misleading results for negative returns - Doesn’t account for asymmetry in return distribution
Value at Risk (VaR)	- Determines maximum potential loss - Easy to interpret for risk managers - Considers extreme scenarios	- Requires assumptions about return distribution - Says nothing about losses exceeding VaR - May underestimate risk in extreme conditions

The four indicators described above - standard deviation, Beta, Sharpe ratio, and Value at Risk - provide important insight into investment risk. By understanding and using these tools, investors can make more informed decisions, balancing potential returns with their own risk tolerance.

Avoiding Excessive Risk Through Diversification

Indicators are one thing, but practice is another. Although knowing the above and being able to interpret them is important, diversification of investments will still remain your best friend. This follows the principle of “don’t put all your eggs in one basket.” Investors are advised to create baskets that contain instruments with higher risk indicators, which can generate higher rates of return, combined with instruments that guarantee lower but more certain income. In the long run, these portfolios will yield the best results. A flagship example is the popular 60/40 portfolio, where 60% of instruments are riskier stocks and 40% are safer treasury bonds. In a simulation for the period from 2012 to 2014, the VaR indicator and potential maximum annual loss over a year is smaller for the 60/40 portfolio than for the S&P 500 index alone.

The 60/40 portfolio will lose less than the S&P 500. Source: Curvo.eu. Source: Curvo.eu

What are the main benefits of this approach?

• Risk reduction: Spreading investments across different assets helps limit the impact of poor performance of a single investment on the entire portfolio.
• Smoother returns: When some investments perform poorly, others may do well, potentially balancing overall returns.
• Capital protection: A well-diversified portfolio is better prepared to survive market downturns.
• Exposure to growth opportunities: You’re not limited to just the local market but also seek opportunities abroad.
• Peace of mind: Knowing that investments are spread across different assets can provide emotional comfort during market volatility. A balanced approach that combines indicator analysis, diversification, and a healthy dose of independent analysis can help you navigate the complex landscape of investment risk more effectively.