Common Measures of Risk in Risk Management

Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

How can investment risk be measured? In this lesson, we'll look at volatility in risk management and three common measures used to assess volatility: range, standard deviation, and beta.

Risk Management

Kiki runs a mutual fund. She wants to figure out how well her fund is doing compared to other funds. Specifically, Kiki wants to know if her fund is keeping her clients' money safer. Can they depend more on Kiki than others?

When she's thinking about dependability and keeping her clients' money safe, Kiki is thinking about risk management, which is about reducing the chances of losing money versus making money. Part of that risk is volatility, which is about fluctuations in returns. Volatility can be about the frequency or the wideness of swings in returns.

Think about it like this: Kiki's fund, like all investments, has some good times and some bad times. Some months and years, the fund makes a lot of money. Other months and years, it loses money. The differences and frequency between the times when the fund makes money and when it loses money is the fund's volatility. Risk management is about reducing that volatility.

So how can Kiki know if her fund is safer than her competitors' funds? One way to understand an investment is through risk measures, which statistically assess how volatile an investment is. To help Kiki understand her fund's performance, let's take a look at three common risk measures: range, standard deviation, and beta.

Range

The first measure that Kiki might use to compare her fund to others is range, which is the difference between the highest and lowest performance. That is, range looks at the spread between the best returns and worst returns of an investment.

For example, if Kiki's best return in the past ten years was a year that her fund had a share price of $100, and her worst returns was a year that the fund had a share price of $10, her range is $90. That's a big range, which indicates a lot of volatility. If one of her competitors has a range that's only $20, that's a much less volatile (and thus less risky) investment.

Standard Deviation

While range is a simple measure of volatility and risk, it's not the only one. Another common risk measure is standard deviation, which is about the degree of variation in an investment's average rate of return. Unlike range, the standard deviation expresses volatility as a percentage.

For example, let's say that Kiki's fund has an average rate of return of 12%. That is, over the past 10 years, it has made an average of 12% per year. But what if the standard deviation was 9%? In that case, Kiki's fund returned between 3% and 21%. That's a huge difference, indicating high volatility.

In contrast, if one of her competitors had an average rate of return of 10% with a 3% standard deviation, that fund returned between 7% and 13%. Their highest return wasn't as high as Kiki's, but their lowest return wasn't as low either, indicating a less volatile investment.

Beta

Both standard deviation and range tell Kiki her fund's volatility. She can use those to compare her fund to other funds. But what about how her fund is doing compared to the stock market in general? Or compared to a specific benchmark?

Beta measures an investment's volatility compared to a benchmark. The benchmark used depends on the investment. Some funds, for example, are meant to mirror the entire stock market, the NASDAQ, or the S&P 500. Some investments use Treasury yields as a benchmark. Whatever the benchmark is, beta looks at whether the investment is more or less volatile than the benchmark.

To unlock this lesson you must be a Study.com Member.
Create your account

Register for a free trial

Are you a student or a teacher?

Unlock Your Education

See for yourself why 30 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back
What teachers are saying about Study.com
Free 5-day trial

Earning College Credit

Did you know… We have over 160 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Transferring credit to the school of your choice

Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.

Create an account to start this course today
Try it free for 5 days!
Create An Account
Support