Risk measures are statistical tools used by investors and finance professionals to make predictions about investment risk. They are part of modern portfolio theory, an approach to portfolio management that relies on the use of standardized tools and predictors to make decisions about how and where to invest. This is designed to limit risks and maximize returns, allowing investors to balance risks versus returns when developing investment strategies and changes to their investment plans.
A number of different analyses can be used as risk measures. One example is the standard deviation, looking at how much the returns on an investment vary from what would be expected, given historical performance and the market. High or low standard deviations can both be indicators of risk, as they may suggest volatility, undervalued stock, or overvalued stock estimates. Another example is the R-squared analysis, comparing movement of a stock with a benchmark or the market to see how much of the stock's price movement can be attributed to the larger economy.
Volatility can be measured with beta risk, by comparing the activity of a stock with a benchmark like a stock index, or the market as a whole. Alpha risk looks at the performance of a stock in comparison with the benchmark or market, providing information about whether it trends high or low. These are some examples of risk measures but many more can be used by investors in the pursuit of more information when making balanced investment decisions.
Brokers and firms maintain their own analysis staff and members of the staff use risk measures on a daily basis to evaluate the direction of the firm's investments and to provide advice to brokers and other staff. Individual investors can do their own risk analysis using risk measures, or take advantage of published information. Financial publications provide this kind of data and some offer online tools so people can access the latest information when they are making choices about investments.
Using risk measures does not create risk-free investment. Statistics provide general information about patterns and trends, but cannot prevent people from being exposed to risk. These tools can be used to select the lowest risks for the highest returns, taking the risk tolerance of an individual investor into account. Markets can be unpredictable and investors may still take losses, even on statistically low-risk investments; after all, if an investment has 95% good returns, someone has to be in the 5% receiving poor returns.
