Feature: RiskGrades: Judging Investment Volatility
by Wayne A. Thorp
Risk permeates every endeavor of humankind. No matter how small, there is risk in everything we do. In the area of investing, risk is very real and something that investors must be aware of. Every financial asset carries with it some level of risk, whether it is a U.S. Treasury bill or the initial public offering of a tech firm.
In this article
- Types of Investment Risk
- Risk and Return
- What is a RiskGrade?
- Portfolio Riskgrade
- Diversification & Portfolio Risk
- "What If" Analysis
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Types of Investment Risk
The American Heritage Dictionary of the English Language defines risk as the possibility of suffering harm or loss. In the context of investing, risk is oftentimes measured in terms of the volatility or variability of expected returns. The higher the potential variability of returns for a given asset, the higher its risk.
Investment risk takes different forms. Inflation is one typethe higher the rate of inflation, the greater the possibility that the real (inflation-adjusted) rate of return will be less than expected. Another risk related to inflation risk is interest rate risk. When interest rates risedue to increased inflation or increases in expected inflation, etc.the values of existing securities decline. Furthermore, the more interest rates increase, the more the price of fixed-income securities falls in order to give investors returns on existing bonds that match returns on newly issued bonds (with higher interest rate payments). On the other hand, when interest rates fall, bond prices rise, creating capital gains and increased returnsagain, causing variations from expected returns and, therefore, risk.
Default riskthe risk that interest or principal will not be paid on timeis an important factor for fixed-income securities such as bonds, short-term notes, or mortgage-related debt. While interest rates and inflation risks affect virtually all securities, default risk is usually confined to individual companies or securities rather than general markets. Default adversely affects returnpotentially dropping realized return well below expected return and, in many situations, creating negative returns.
Employing leverageborrowing to investwill magnify the variability of return, no matter the inherent variability of an investment. Borrowing, or buying securities on margin, means a smaller investment base is present, and changes in price and dividends will cause greater percentage returns, both positive and negative. Additionally, financial leverage implies an interest payment obligation on the part of the borrower, increasing the negative returns and reducing positive returns by the amount of the interest payment.
Other forms of risk to consider are industry and firm risk. Events within the firm and industrysuch as strikes, raw material shortages or cost changes, management error, product defects and innovationscause variations in the price of common stocks, and sometimes bonds, and also enhance or jeopardize dividend streams (or interest payments).
Risk and Return
One of the most basic tenets of investing is the relationship between risk and return: in order to achieve a greater level of return, in general, you will have to be willing to take on a greater level of risk. To see this, let us examine the average return of Treasury bills, which are virtually risk-free, and that of a stock index such as the S&P 500. According to Ibbotson Associates, the average annual return for the S&P 500 from 1926 through 2002 was 12.2%, while U.S. Treasury bills averaged a 3.8% annual return. In other words, $1 invested in the S&P 500 at the end of 1925 would have grown to $1,775.34 by the end of 2002, while the same $1 invested in T-bills over the same period would have only grown to $17.48, a difference of over 10,000%. Looking at the risk of these two asset classes, the standard deviation of returns for the S&P 500 was 20.5% per year over the same period and was 3.2% for T-bills. Standard deviationa popular measure of riskmeasures the dispersion or variation around an average. While the S&P 500 outperformed T-bills by over eight percentage points a year, its returns were more than six times as volatile as those of Treasury bills (0.205 ÷ 0.032 = 6.4).
While in this case, investing in assets that have higher riskgreater variability of returnsgenerated higher overall gains compared to lower risk/volatility assets, keep in mind that this was over a 76-year period and that risk is a two-way street. Riskier assets carry the potential for greater gains and greater losses than lower-risk assets, especially over shorter time periods.
Many investors fail to take this into account and are only concerned with the returns they are able to generateno matter how much risk they have to assume to generate those returns. The Internet bubble was a painful reminder to many that high-risk is intoxicating on the way up and potentially devastating on the way down.
The site is free to individual investors. However, to make use of some of its unique features, you will need to register at the site.
What is a RiskGrade?
The cornerstone of the analysis provided at the RiskGrades Web site is the RiskGrade measure. The RiskGrade is a standardized measure of volatility based upon the volatility of returns for a given financial asset. A RiskGrade is calculated by first measuring the variation of an assets price, with more emphasis placed on the most recent price history, and then comparing the assets volatility to the volatility of a basket of global equities. The ratio of these two volatilities is the assets RiskGrade measure. (For a detailed description of how RiskGrades are calculated, visit the Help Section of the RiskGrades Web site. There, you will find an overview of the calculation as well as a technical document that provides an in-depth discussion of the math behind RiskGrades.)
RiskGrades are scaled from zero (for assets such as cash) to values exceeding 1,000. The higher the volatility of returns for an asset, the higher its RiskGrade measure.
RiskGrades allow investors to compare one assets risk to anothers, compare the risk of a portfolio to the risk of an index or benchmark, as well as compare the risk of a portfolio to that of another portfolio. Through the course of this article, we will explore the uses of RiskGrades.
When comparing the RiskGrade of different assets, there is a linear relationship. In other words, an asset with a RiskGrade of 600 is twice as volatile as another asset with a RiskGrade of 300 (600 ÷ 300 = 2). As a reference point, a RiskGrade of 100 corresponds to the average RiskGrade of a diversified, market-cap-weighted index of international equities during normal market conditions. This reading of 100 corresponds to an annualized standard deviation of return of 20%, which was approximately the risk of the international equity index for the period from 1995 to 1999. A RiskGrades are dynamic and, as such, will change over time to reflect the current market conditions.
RiskGrade values are available for a wide variety of financial assets, including individual equities, mutual funds, bonds, and currencies. A RiskGrade is a standardized measure of volatility/risk, meaning you can do an apples-to-apples comparison of risk across asset classes and geographic regions.
Beyond being a standardized measure of risk that allows for a comparison of dissimilar assets, the RiskGrade is beneficial in that it captures the various components of market riskequity, interest rate, currency, and commodity risk.
Currency risk has become a legitimate element of investing as more investors look outside their own countrys borders for investment opportunities. For someone in Japan, holding yen carries no risk (irrespective of inflation) and, therefore, this investment has a RiskGrade of zero. However, an American holding yen faces currency risk and, consequently, the RiskGrade of yen from a U.S. dollar standpoint is greater than zero. Looking at equity investments, an American who buys Japanese stock is exposed to two sources of riskcurrency risk as well as equity risk. Total return is impacted not only by the fluctuation in the stocks price, but also by the yen/U.S. dollar exchange-rate fluctuations. Therefore, the RiskGrade of a Japanese stock held by an American investor is different from the RiskGrade of the same stock held by a Japanese investor. RiskGrade captures the currency risk component of investing and predicts the total risk of an investment. The RiskGrades Web site is able to denominate securities in several currencies: the U.S. dollar, the euro, British pound, Japanese yen, and the Canadian dollar.
When creating an investment plan, it is important to consider the interaction between the investments in your collectionrather than viewing assets in isolation. In other words, you should take a portfolio view of your investments.
Beyond measuring the volatility of individual assets, the RiskGrades Web site can also calculate RiskGrade values for a group of assets held as a portfolio. Using this Web site, you are able to see how adding or removing assets from you investment portfolio will affect the overall volatility of the portfolio. The RiskGrade of a portfolio, just as with an individual asset, measures the volatility of the portfolios market value.
Table 1 shows the RiskGrades for a group of stocks, mutual funds, and stock indexes. The RiskGrade values range from a low of 10 for the Vanguard Short-Term Bond Index fund to a high of 154 for Microsoft Corporation. The table also shows that the RiskGrade for each of the four stocks is larger than the RiskGrade for any of the equity mutual funds or indexes. General Electric Company, with a RiskGrade of 144, is over 38% riskier than the S&P 500 index with its RiskGrade measure of 104 ([144 ÷ 104] 1 = 0.385 or 38.5%). This illustrates the need to pay attention to the interaction between investments in the overall portfolio, which brings us to the discussion of diversification.
|Table 1. Sample RiskGrades|
|General Electric Company (GE)||144|
|Microsoft Corporation (MSFT)||154|
|Pfizer Inc. (PFE)||120|
|Wal-Mart Stores, Inc. (WMT)||128|
|Vanguard Short-Term Bond Index (VBISX)||10|
|Vanguard 500 (VFINX)||106|
|Vanguard Small Cap Growth Index (VISGX)||91|
|*As of 5/6/2003.|
Diversification & Portfolio Risk
In the stock market, two primary factors will cause a stocks return to varychanges in the firm or the way investors perceive the firm, and movements in the overall stock market. Therefore, there are two components to stock risk that an investor faces: market risk, which is inherent in the stock market itself; and firm risk, which is associated with the unique characteristics of any one stock and the industry in which it operates.
One of the most popular methods used to reduce the variability (risk) of an investment portfolio is diversification. Stocks do not move in tandemnot every stock will go up or down on a given trading day. The degree to which assets do tend to move together is called their correlation. The idea of diversification is to select assets that have a low correlation or negative correlation. A portfolio containing 10 technology stocks would not benefit from diversification as much as one with 10 stocks from differing, unrelated industries. Assets that have a low correlation with each other will move in the same direction, but not by the same amount, whereas assets that are negatively correlated will move in the opposite direction of each other. Diversification can be examined by other factors such as sector, geography, and asset class. In each case, the argument is the same: stocks in differing sectors or geographic regions will not move the same way, nor will different types of assets, such as stocks and bonds.
Figure 2 shows a portfolio created within the RiskGrades Web site that is made up of the four stocks listed in Table 1, with each having approximately $10,000 invested in it (the market value of each holding is shown on the right-hand side Figure 2). Once you have registered with the RiskGrades Web site and logged in, you can create different portfolios with stocks, mutual funds, and bonds, both domestic and international. The columns shown in Figure 2 are the default columns provided by the Web site. However, you can customize the columns displayed. As shown at the bottom left-hand side of Figure 2, the RiskGrade for this portfolio of stocks is 117, which is lower than the RiskGrade for each of the four component stocks. For any portfolio, the portfolio RiskGrade will be less than the weighted average of the RiskGrades of the individual assets held in the portfolio. In this case, the weighted average would be approximately 137 ([144 + 154 + 120 + 128] ÷ 4). This is due to diversification.
When calculating the RiskGrade of a portfolio, the site considers the following: the RiskGrade for each asset, the correlation of each asset to every other asset in the portfolio, and the size of each assets position in the portfolio.
Below the Portfolio RiskGrade of 117 displayed in Figure 2 is a Diversification Benefit value of 19. The RiskGrade Diversification Benefit for a portfolio is the difference between the computed portfolio RiskGrade (in this case, 117) and the market-value-weighted average of the portfolio holdings RiskGrades. The market-value-weighted RiskGrade for this portfolio is calculated by multiplying the RiskGrade of an individual asset by its percentage of the overall portfolio. For this portfolio, the market-value-weighted RiskGrade is 136 ([144 × 0.2498] + [154 × 0.2489] + [120 × 0.2499] + [128 × 0.2513] = 136.45). Deducting the RiskGrade value produced by the site (117) from the market-value-weighted RiskGrade for the portfolio (136) gives us the diversification benefit of 19 (136 117 = 19).
Now that we know the RiskGrade of our overall portfolio, as well as the diversification benefit produced by the combination of various assets into a single portfolio, we can manage that risk by seeing the impact of adding or removing assets from the portfolio. To help in this process, the site offers two additional tools: RiskImpact and XLoss.
The RiskImpact of an asset measures how much the portfolio RiskGrade would change if the asset were removed (the position closed and the proceeds held as cash). The RiskImpact can be used to highlight concentration risks within a portfolio. The RiskImpact of an asset is the difference between the RiskGrades of a portfolio with and without the asset.
Returning to Figure 2, we see that the RiskImpact for the four stocks in the portfolio ranges from 17% for Pfizer to 27% for Microsoft Corporation. The RiskImpact of 27% for Microsoft means that if we sold all of the $9,853 invested in Microsoft and kept the proceeds in cash, the portfolio RiskGrade would be reduced by 27%, from 117 to 85 ([117 × (1 0.27)] = 85.4 or 85).
Beyond allowing you to assess the way in which an asset affects the risk of an existing portfolio, RiskImpact allows you to consider what will happen when you add new positions to a portfolio. As an extreme example, Figure 3 shows that we have added a stock to our existing portfolio: Genelink, Inc. (GLNK), an over-the-counter bulletin board stock specializing in identification kits that use DNA. Genelinks RiskGrade value is 978, which makes it almost eight times as risky as a basket of international equities during normal market conditions. Adding this stock has pushed the portfolio RiskGrade from 117 up to 226, a 93% increase.
If we had created our portfolio with these five stocks to begin with, we would not have known that adding Genelink would increase the RiskGrade by 93%. So the RiskImpact figure gives us this information. Genelinks RiskImpact of 59% clearly shows that much of the portfolios risk is attributable to Genelink. Armed with this knowledge, we may not be willing to make such a large investment in Genelink, or any at all.
Looking back to Figure 2, note that the RiskImpact for an individual asset within a portfolio will change as you add assets to or remove assets from the portfolio. The RiskImpact values in Figure 2 range from 17% to 27%, whereas in Figure 3 they range from 4% to 59%. This change was brought about by simply adding one additional stock to the fray.
A RiskGrade allows us to see how volatile a portfolio or individual asset is relative to a basket of international equities, as well as make an apples-to-apples comparison of risk across different asset types. RiskImpact allows us to examine how adding or removing assets will affect the overall risk profile of a portfolio. A third measure provided by the RiskGrades Web siteloss on extreme days, or XLossaddressees the issue of how much you could lose during extreme market movements. XLoss measures the expected loss in adverse conditions, where an adverse condition is defined as price fluctuation of 95% or more of typical daily price changes. XLoss provides an indication of your potential losses in extreme markets, not a forecast of the worst-case loss. From a statistical standpoint, half of your extreme losses are likely to be greater than XLoss, as it is an average measure of worst-case loss.
XLoss is calculated by first examining the daily performance of an asset for each trading day of the previous year. An assumption underlying this approach is that you owned the same mix of assets for each day of the previous year. The portfolio XLoss is the average of the worst 5% of the historical daily returns for the portfolio.
Unlike RiskImpact, the XLoss of an individual asset does not change with changes in the portfolio because it is based solely on the average losses for that asset on the worst market days of the year.
Just as there was a RiskGrade Diversification Benefit, so too is there an XLoss Diversification Benefit. For a portfolio, the XLoss Diversification Benefit is the difference between the sum of the individual asset XLoss values and the computed XLoss of the portfolio. For the portfolio in Figure 3, the XLoss Diversification Benefit is the difference between the sum of the individual asset XLoss values ($399 + $2,492 + $440 + $315 + $343 = $3,989) and the actual XLoss for the portfolio ($2,916), which is $1,073 ($3,989 $2,916).This, again, is due to the fact that the stocks in the portfolio are not perfectly correlated (do not move in exactly the same way).
- The Chart Center (CC) allows you to graph a RiskChart that tracks the portfolios RiskGrade historically. You can select predefined time periods or choose a specific time frame.
- The Risk vs. Return Chart (RA) allows you to see if you are being properly compensated for the amount of risk you are taking. The chart plots each asset in the portfolio along with a line illustrating the average return of an asset with a certain RiskGrade. Assets plotted above the line are implied to be generating sufficient returns for their level of risk, while those below the line are generating a return that is inadequate given their level of risk.
- The Graphical View provides charts illustrating the risk profile of the entire portfolio, asset classes, and individual assets.
- With the sector/asset class analysis (FA) (Figure 4), you can analyze your investment style against benchmark indexes, as well as examine sector and asset class weightings and risk levels within a portfolio. You can use this information to see the impact on your portfolio value of various sectors and asset classes.
- The RiskRanking (RR) view shows how a portfolio compareson a risk basisto benchmark indexes or the portfolios of other registered users.
"What If" Analysis
One final feature of the RiskGrades Web site to aid you in portfolio risk analysis is What If analysis. Here, you can see how potential changes in your investments will influence your portfolio. By adding, deleting, or adjusting the amount you own of an asset, the What If analysis allows you to view the impact of the change(s) on your portfolios risk profile.
While risk plays an important role in investing, investors often lack the tools to assess the riskiness of their investments or their overall portfolio. With the RiskGrades Web site, users can gain an understanding of the risk of an individual asset and compare that risk to other assetseven if they are in different asset classes. The site allows you to assess the risk profile of a portfolio, analyze the impact of individual assets on overall portfolio risk, and run analyses to see how altering the asset mix will impact portfolio risk.
Wayne A. Thorp, CFA, is associate editor of Computerized Investing and AAIIs financial analyst.