How to analyse risk involved in investment...

There are five main indicators of investment risk that relate to the analysis of stocks, bonds and mutual fund portfolios. They are alpha,beta,r-squired standard deviation and the Sharpe. These statistical measures are historical predictors of investment risk/volatility and are all major components of Modern portfolio theory (MPT). The MPT is a standard financial and academic methodology used for assessing the performance of equity, fixed-income and mutual fund investments by comparing them to market benchmarks.

All of these risk measurements are intended to help investors determine the reward parameters of their investments. In this article, we'll give a brief explanation of each of these commonly used indicators.

1. Alpha
Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its "alpha".

Simply stated, alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio's return. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%. For investors, the more positive an alpha is, the better it is.

2. Beta
Beta, also known as the "beta coefficient," 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 calculated using regression analysis, and you can think of it as the tendency of an investment's return to respond to swings in the market. By definition, the market has a beta of 1.0. Individual security and portfolio values are measured according to how they deviate from the market.

A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market, and, correspondingly, a beta of more than 1.0 indicates that the investment's price will be more volatile than the market. For example, if a fund portfolio's beta is 1.2, it's theoretically 20% more volatile than the market.

Conservative investors looking to preserve capital should focus on securities and fund portfolios with low betas, whereas those investors willing to take on more risk in search of higher returns should look for high beta investments.

3. R-Squared
R-Squared is a statistical measure that represents the percentage of a fund portfolio's or security's movements that can be explained by movements in a benchmark index. For fixed-income securities and their corresponding mutual funds, the benchmark is the US Treasury bills and, likewise with equities and equity funds, the benchmark is the S&P 500.

R-squared values range from 0 to 100. According to Morningstar a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less would not perform like the index.

Mutual fund investors should avoid actively managed funds with high R-squared ratios, which are generally criticized by analysts as being "closet" Index Fund In these cases, why pay the higher fees for so-called professional management when you can get the same or better results from an index fund.

4. Standard Deviation
Standard deviation measures the dispersion of data from its mean. In plain English, the more that data is spread apart, the higher the difference is from the norm. In finance, standard deviation is applied to the annual return on investment of an investment to measure its volatility (risk). A volatile stock would have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

5. Sharpe Ratio
Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted performance. It is calculated by subtracting the risk free rate of return from the rate of return for an investment and dividing the result by the investment's standard deviation of its return.

The Sharpe ratio tells investors whether an investment's returns are due to smart investment decisions or the result of excess risk. This measurement is very useful because although one portfolio or security can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater an investment's Sharpe ratio, the better its risk-adjusted performance.

Conclusion
Many investors tend to focus exclusively on investment return, with little concern for investment risk. The five risk measures we have just discussed can provide some balance to the risk-return equation. The good news for investors is that these indicators are calculated for them and are available on several financial websites, as well as being incorporated into many investment research reports. As useful as these measurements are, keep in mind that when considering a stock, bond, or mutual fund investment, volatility risk is just one of the factors you should be considering that can affect the quality of an investment.

source:Investopedia.com

There are five main indicators of investment risk that relate to the analysis of stocks, bonds and mutual fund portfolios. They are alpha,beta,r-s standard deviation and the Sharpe. These statistical measures are historical predictors of investment risk/volatility and are all major components of Modern portfolio theory (MPT). The MPT is a standard financial and academic methodology used for assessing the performance of equity, fixed-income and mutual fund investments by comparing them to market benchmarks.

All of these risk measurements are intended to help investors determine the reward parameters of their investments. In this article, we'll give a brief explanation of each of these commonly used indicators.

1. Alpha
Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of a security or fund portfolio and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its "alpha".

Simply stated, alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio's return. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%. For investors, the more positive an alpha is, the better it is.

2. Beta
Beta, also known as the "beta coefficient," 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 calculated using regression analysis, and you can think of it as the tendency of an investment's return to respond to swings in the market. By definition, the market has a beta of 1.0. Individual security and portfolio values are measured according to how they deviate from the market.

A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market, and, correspondingly, a beta of more than 1.0 indicates that the investment's price will be more volatile than the market. For example, if a fund portfolio's beta is 1.2, it's theoretically 20% more volatile than the market.

Conservative investors looking to preserve capital should focus on securities and fund portfolios with low betas, whereas those investors willing to take on more risk in search of higher returns should look for high beta investments.

3. R-Squared
R-Squared is a statistical measure that represents the percentage of a fund portfolio's or security's movements that can be explained by movements in a benchmark index. For fixed-income securities and their corresponding mutual funds, the benchmark is the U.S. Treasury Bill and, likewise with equities and equity funds, the benchmark is the S&P 500 Index.

R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less would not perform like the index.

Mutual fund investors should avoid actively managed funds with high R-squared ratios, which are generally criticized by analysts as being "closet" index funds. In these cases, why pay the higher fees for so-called professional management when you can get the same or better results from an index fund.

4. Standard Deviation
Standard deviation measures the dispersion of data from its mean. In plain English, the more that data is spread apart, the higher the difference is from the norm. In finance, standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk). A volatile stock would have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.

5. Sharpe Ratio
Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate of return (U.S. Treasury Bond) from the rate of return for an investment and dividing the result by the investment's standard deviation of its return.

The Sharpe ratio tells investors whether an investment's returns are due to smart investment decisions or the result of excess risk. This measurement is very useful because although one portfolio or security can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater an investment's Sharpe ratio, the better its risk-adjusted performance.

Conclusion
Many investors tend to focus exclusively on investment return, with little concern for investment risk. The five risk measures we have just discussed can provide some balance to the risk-return equation. The good news for investors is that these indicators are calculated for them and are available on several financial websites, as well as being incorporated into many investment research reports. As useful as these measurements are, keep in mind that when considering a stock, bond, or mutual fund investment, volatility risk is just one of the factors you should be considering that can affect the quality of an investment

Less known investment option.

The Money Market

The money market is a subset of the fixed-income market. In the money market, participants borrow or lend for short period of time, usually up to a period of one year. These instruments are generally traded by the Government, financial institutions and large corporate houses. These securities are of very large denominations, very liquid, very safe but offer relatively low interest rates. The cost of trading in the money market (bid-ask spread) is relatively small due to the high liquidity and large size of the market. Since money market instruments are of high denominations they are generally beyond the reach of individual investors. However, individual investors can invest in the money markets through money-market mutual funds. We take a quick look at the various products available for trading in the money markets.

T-Bills

T-Bills or treasury bills are largely risk-free (guaranteed by the Government and hence carry only sovereign risk - risk that the government of a country or an agency backed by the government, will refuse to comply with the terms of a loan agreement), short-term, very liquid instruments that are issued by the central bank of a country. The maturity period for T-bills ranges from 3-12 months. T-bills are circulated both in primary as well as in secondary markets. T-bills are usually issued at a discount to the face value and the investor gets the face value upon maturity. The issue price (and thus rate of interest) of T-bills is generally decided at an auction, which individuals can also access. Once issued, T-bills are also traded in the secondary markets. In India, T-bills are issued by the Reserve Bank of India for maturities of 91-days, 182 days and 364 days. They are issued weekly (91-days maturity) and fortnightly (182-days and 364- days maturity).

Commercial Paper

Commercial papers (CP) are unsecured money market instruments issued in the form of apromissory note by large corporate houses in order to diversify their sources of short-term borrowings and to provide additional investment avenues to investors. Issuing companies are required to obtain investment-grade credit ratings from approved rating agencies and in some cases, these papers are also backed by a bank line of credit. CPs are also issued at a discount to their face value. In India, CPs can be issued by companies, primary dealers (PDs), satellite dealers (SD) and other large financial institutions, for maturities ranging from 15 days period to 1-year period from the date of issue. CP denominations can be Rs. 500,000 or multiples thereof. Further, CPs can be issued either in the form of a promissory note or in dematerialized form through any of the approved depositories.

Certificates of Deposit

A certificate of deposit (CD), is a term deposit with a bank with a specified interest rate. The duration is also pre-specified and the deposit cannot be withdrawn on demand. Unlike other bank term deposits, CDs are freely negotiable and may be issued in dematerialized form or as a Usance Promissory Note. CDs are rated (sometimes mandatory) by approved credit rating agencies and normally carry a higher return than the normal term deposits in banks (primarily due to a relatively large principal amount and the low cost of raising funds for banks). Normal term deposits are of smaller ticket-sizes and time period, have the flexibility of premature withdrawal and carry a lower interest rate than CDs. In many countries, the central bank provides insurance (e.g. Federal Deposit Insurance Corporation (FDIC) in the U.S., and the Deposit Insurance and Credit Guarantee Corporation (DICGC) in India) to bank depositors up to a certain amount (Rs. 100000 in India). CDs are also treated as bank deposit for this purpose. In India, scheduled banks can issue CDs with maturity ranging from 7 days – 1 year and financial institutions can issue CDs with maturity ranging from 1 year – 3 years. CD are issued for denominations of Rs. 1,00,000 and in multiples thereof.