Measures of Risk
In investing, risk refers to the possibility of losing some or all of the money invested. There are several measures of risk that investors use to evaluate investments and manage their portfolio risk. Here are some of the most common measures of risk:
Standard Deviation: Standard deviation measures the variability of an investment’s returns from its average return. A higher standard deviation indicates higher volatility and greater potential risk.
Beta: Beta measures an investment’s sensitivity to market movements. A beta of 1 indicates that the investment moves in line with the market, while a beta greater than 1 indicates that the investment is more volatile than the market. A beta less than 1 indicates that the investment is less volatile than the market.
Value at Risk (VaR): VaR estimates the maximum loss an investment may suffer with a given level of confidence over a specified time period. For example, a VaR of 10% for a portfolio of $100,000 means that there is a 10% chance that the portfolio will lose more than $10,000 over a specified time period.
Sharpe Ratio: The Sharpe ratio measures the excess return earned by an investment compared to the risk-free rate of return for each unit of risk. A higher Sharpe ratio indicates better risk-adjusted returns.
Sortino Ratio: The Sortino ratio is similar to the Sharpe ratio, but it only considers downside risk, which is the risk of losses below a certain threshold. A higher Sortino ratio indicates better risk-adjusted returns when considering downside risk.
Maximum Drawdown: Maximum drawdown is the maximum loss an investment has experienced from its peak value. It measures the downside risk of an investment and can be used to evaluate the worst-case scenario for an investment. These measures of risk are not exhaustive, and investors may use other metrics or combinations of metrics to evaluate risk. It is important to consider multiple measures of risk when evaluating an investment and to understand the limitations of each measure.
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