We say that risk and returns go hand in hand, which means if you want to increase returns on your investments, you need to take more risks. But how does one measure risk and then control it?
Returns are easy to calculate and it may be due to this fact that most of us look at returns from various investment options while trying to decide which investment to go for. Typically even third party advisors provide synopsis of returns generated by various investment alternatives as the basis of selection of products to invest into.
However, returns provide only a part of the story, the other and perhaps even more important part is the risk that the investment carries. From a common sense perspective, risk is the possibility of not getting your desired returns at some time in the future. With products that have variability of returns, it is difficult to predict what the returns will actually be, upfront. However, there are ways in which this variability can be measured and can provide some indication of the future as well.
If the fluctuation of an investment is high, it carries a higher probability of having a large difference between what returns were expected and what were eventually delivered. Another explanation of the same is that returns are point to point, so one-year return means the change in value of the investment from what it was one year back, to today. Risk is a deeper analysis where you look at not only the returns, but also the path that has been taken to generate these returns. Two investments that have the same return after one year may not have the same risk associated with them.
One may have had a more stable consistent and gradual build-up to the returns generated while the other might have had significant bouts of upswing and negatives over the same period whilst generating the same returns. Obviously, the first is a better alternative. This path that the investment takes where the value goes up and down in the interim is captured by a risk measure called Standard Deviation. Standard Deviation basically means how much have the interim values departed from the mean rate of return.
The mean rate of return is a hypothetical per period return that if taken as a constant would add up to the rate of return delivered by the investment in one year. For example, if Rs 100 invested one year back are worth `110 today, a total one-year return of 10% has been generated. If there are 300 working days in the year, the constant daily return that will lead to a cumulative 10% return after a year would be 0.032% for every working day. This becomes the mean daily rate of return.
But the value of the underlying investment would probably not have gone up by exactly 0.032% each day over the one year period. This is especially true for equities where stock prices and index values go up and down on a daily basis. So, were there wild swings around this 0.032% per day return or was there a moderate variation from this constant daily return. That is captured by the Standard Deviation and it is probably the single most important risk measure to be looked at.
The other risk measures to look for with respect to equities is Beta which is the correlation of the stock with a market index. If the Beta is high, that means the stock moves both up and down rapidly with market movements, while a low beta suggests that the stock is more stable in such market movements. Risk parameters like the Standard Deviation and Beta can also be calculated for a portfolio or a mutual fund scheme, apart from individual stocks.
This means you can calculate the value of the portfolio every day and see how it varies on a day-to-day basis vs. the mean. Similarly, you can study the daily NAV of a mutual fund scheme to analyse its risk. Mutual funds also have to disclose these parameters in their monthly fact sheets. It would be greatly beneficial to start looking at these parameters along with the returns generated, before making a decision to invest into a particular stock, portfolio or mutual fund scheme.
(The author is the founder of Five Rivers Portfolio Managers)