When you work with a financial advisor, it’s often up to you how much you want to know about your investments. Many investors choose to let their advisor make most of the decisions and don’t feel the need to look under the hood. But for hands-on investors, the more you learn about how your portfolio can be analyzed and measured, the more informed you’ll be in your decisions.
These concepts are advanced and complex. There’s no single measurement that can tell you whether an investment is good or bad. But, by learning about the different types of measurements your advisor uses, you can be an educated decisionmaker for your own investments.
Measures of Risk
Risk is a vital measurement to know about any individual asset. We all know that high risk can result in high rewards, but we also know that it’s vital to balance a portfolio with a large percentage of low-risk investments. To do that, of course, an investor needs to know how risky an asset is. To measure that risk, some analysis is necessary.
Standard Deviation
In math, the standard deviation is a measurement of how much individual numbers fluctuate from the mean. In investments, it measures volatility: how much general rise and fall in value we can expect over time. For instance, an investment which consistently returns 5% every year would have a standard deviation of zero—it doesn’t change at all. Whereas an investment which sometimes loses 5% and sometimes gains 15% could also have an average return of 5%, but the standard deviation would be much higher. A low standard deviation means less risk, while a high standard deviation means high risk.
When looking at two securities with the same rate of return, you’d want to pick the one with the lower standard deviation. The lower volatility you can have for a given return percentage, the better. That means you’re more sure to receive those returns every year. Remember, however, that standard deviation is a record of past performance. Nobody can tell you for sure it will continue to be stable in the future.
Beta
Beta is a risk measurement that compares an asset to a benchmark, such as the S&P 500. What analysts are doing with this is rating the asset as either more or less volatile than the benchmark. An asset with a beta near 1 is tracking very close to the benchmark. An asset with a higher number is more volatile than that benchmark. For instance, an asset with a beta of 2 is twice as volatile as its benchmark. So if we compare it to the S&P 500, when the S&P goes up 5%, it would go up 10%. Great, right? But when the S&P goes down 5%, we would expect the same asset to go down 10%. Not so great.
In general, experts prefer investments with a high beta value when the market is doing well, because then they can outperform an already bullish market. But they prefer investments with a lower beta value when the market is bearish, because they can minimize losses.
R-Squared
This measurement describes how closely an investment tracks with its benchmark. After all, the beta measurement is not very useful unless we know the asset predictably tracks what the benchmark is doing. An r-squared measurement of 100 would mean that the asset perfectly mirrors the benchmark, and therefore the beta value is highly relevant. But an r-squared measurement of 0 means the asset moves completely independently of the benchmark. You’d never use a beta measurement in that case, because it would tell you nothing. Perhaps the asset needs to be measured against a different benchmark.
Alpha
The alpha is a measurement of how well the asset performed given its risk. Since risk should only be accepted to win higher returns, it doesn’t simply measure performance. Instead, it measures performance corrected for the amount of risk you had to take on to get that result. If that number is negative, you are taking on too much risk and not getting adequately compensated for it. You could buy less volatile investments and do just as well.
The Efficient Frontier
Risk, of course, is only one factor in investment decisions. Your portfolio should also be measured in terms of diversification, performance, tax efficiency, and more. But measuring the risk of an asset allows you to place it on a chart mapping it against its performance. Financial analysts can draw a line on this chart called the efficient frontier. This line signifies the set of investments that are optimally balanced between risk and reward. If your investments are close to this line and spread out along it, you’re probably doing a good job balancing risk with performance. But if each individual investment is along the line (meaning it offers good enough rewards for the risk you take), that doesn’t necessarily equal a good portfolio. A balanced portfolio will include both high and low risk investments.
Talk to Your Advisor
If you want to be a more hands-on investor, let your advisor know. They’re happy to work with informed investors, and are your best source for education about how they are measuring your investments. If your advisor balks at telling you anything, while you’re interested in keeping up-to-date with what’s happening, you might not be a perfect match. To find your ideal financial advisor, contact us today and tell us you want to be involved in your own portfolio. The right advisor will enable you to be an active partner in your investments.
