V.16:12 (559-562): Measuring Risk by Dick Stoken

There are two common ways to measure performance: the standard deviation of returns and the Sharpe ratio. Here's a third way.

How do we measure risk? In the financial industry, the generally accepted method is the standard deviation of returns. A low standard deviation indicates that expected returns vary little from average returns (suggesting less risk), while a high standard deviation suggests that expected returns vary greatly from average returns (implying more risk). The assumption is that stable past returns are less risky, yet many practitioners are uneasy with this concept.

FACTORING IN LOSSES

Let’s examine a risk measure that factors in the actual losses experienced by asset managers. Say that portfolio manager Dick Smith experienced two negative years of -2.7% and -7.9%, a combined loss totaling -10.6% over a 25-year period. By dividing this total loss by the number of years in our observation (25), we derive an average loss of -0.42% per year. This is the average loss that an investor would have experienced had he bought at the beginning of a negative period, sold at the end of that span, and stayed on the sidelines in the interim.

Let us also suppose that during that same 25-year period, the Standard & Poor’s 500 was down a total of five years for a combined loss of -56.7%, averaging -2.27% a year. When viewed from this perspective, Smith’s portfolio was clearly less risky than the S&P 500.