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INVESTING PORTFOLIO MANAGEMENT

What Are the 5 Principal Risk Measures

and How Do They Work?
By JAMES CHEN Updated March 30, 2020

Reviewed by GORDON SCOTT

What Are Risk Measures?

Risk measures are statistical measures that are historical predictors of
investment risk and volatility, and they are also major components in modern
portfolio theory (MPT). MPT is a standard financial and academic methodology
for assessing the performance of a stock or a stock fund as compared to its
benchmark index.

There are five principal risk measures, and each measure provides a unique way
to assess the risk present in investments that are under consideration. The five
measures include the alpha, beta, R-squared, standard deviation, and Sharpe
ratio. Risk measures can be used individually or together to perform a risk
assessment. When comparing two potential investments, it is wise to compare
like for like to determine which investment holds the most risk.

KEY TAKEAWAYS

• Risk measures are statistical measures that are historical predictors of

investment risk and volatility.

• Risk measures are also major components in modern portfolio theory

(MPT), a standard financial methodology for assessing investment
performance.

• The five principal risk measures include the alpha, beta, R-squared,
standard deviation, and Sharpe ratio.

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Understanding Risk Measures TRADE
Alpha
Alpha measures risk relative to the market or a selected benchmark index. For
example, if the S&P 500 has been deemed the benchmark for a particular fund,
the activity of the fund would be compared to that experienced by the selected
index. If the fund outperforms the benchmark, it is said to have a positive alpha.
If the fund falls below the performance of the benchmark, it is considered to
have a negative alpha.

Beta
Beta measures the volatility or systemic risk of a fund in comparison to the
market or the selected benchmark index. A beta of one indicates the fund is
expected to move in conjunction with the benchmark. Betas below one are
considered less volatile than the benchmark, while those over one are
considered more volatile than the benchmark.

R-Squared
R-Squared measures the percentage of an investment's movement attributable
to movements in its benchmark index. An R-squared value represents the
correlation between the examined investment and its associated benchmark.
For example, an R-squared value of 95 would be considered to have a high
correlation, while an R-squared value of 50 may be considered low.

The U.S. Treasury Bill functions as a benchmark for fixed-income securities,

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The U.S. Treasury Bill functions as a benchmark for fixed-income securities,
while the S&P 500 Index functions as a benchmark for equities. TRADE

Standard Deviation
Standard deviation is a method of measuring data dispersion in regards to the
mean value of the dataset and provides a measurement regarding an
investment’s volatility.

As it relates to investments, the standard deviation measures how much return

on investment is deviating from the expected normal or average returns.

Sharpe Ratio
The Sharpe ratio measures performance as adjusted by the associated risks.
This is done by removing the rate of return on a risk-free investment, such as a
U.S. Treasury Bond, from the experienced rate of return.

This is then divided by the associated investment’s standard deviation and

serves as an indicator of whether an investment's return is due to wise investing
or due to the assumption of excess risk.

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Related Terms
Understanding Risk-Adjusted Return and Measurement
Methods
A risk-adjusted return accounts for the riskiness of an investment compared to the risk-
free rate of return. more

Alpha: What It Means in Investing, With Examples

Alpha (α) , used in finance as a measure of performance, is the excess return of an
investment relative to the return of a benchmark index. more

What Is Risk Management in Finance, and Why Is It

Important?
In the financial world, risk management is the process of identification, analysis, and
acceptance or mitigation of uncertainty in investment decisions. more

Standard Deviation Formula and Uses vs. Variance

The standard deviation is a statistic measuring the dispersion of a dataset relative to its
mean and is calculated as the square root of the variance. more

R-Squared: Definition, Calculation Formula, Uses, and

Limitations
R-squared is a statistical measure that represents the proportion of the variance for a
dependent variable that’s explained by an independent variable. more

Risk-Return Tradeoff: How the Investment Principle Works

Risk-return tradeoff is a fundamental trading principle describing the inverse relationship
between investment risk and investment return. more

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D i g i ta l s t o c k QUANTITATIVE ANALYSIS
m a r ke t c h a r t What's the Relationship Between R-Squared and
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h a n d catc h i n g Common Methods of Measurement for Investment
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How Morningstar Rates and Ranks Mutual Funds

C a l c u l ato r a n d PORTFOLIO MANAGEMENT

C h a r ts Measuring a Portfolio's Performance

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