Resident IFA Blog

Volatility is the word

Mon, 16th Aug 2010 - Author: Resident IFA

If you are a serious investor, you may have heard of the following 4 terms that measure volatility/risk:

Standard Deviation

Standard Deviation is useful for two reasons: Firstly, because the more a fund's return fluctuates, the riskier the fund is likely to be standard deviation facilitates comparisons across all types of funds. Secondly because funds that have been more volatile in the past tend to be the more volatile in the future. In that sense, standard deviation is a useful warning sign. The standard deviation is expressed in percentage terms, just like the returns. It is calculated based on the fund’s most recent 36 monthly returns. The simplest use is to compare funds. Additionally, you can estimate the range of returns that a fund can experience in any given year. This gives a useful estimate of how low returns can go.

Sharpe Ratio

The Sharpe ratio is calculated for the past 36-month period by dividing a fund’s excess returns by the standard deviation of a fund’s excess returns. Since this ratio uses standard deviation as its risk measure, it is most appropriately applied when analysing a fund that is an investor's sole holding. The Sharpe Ratio can be used to compare two funds directly on how much risk a fund had to bear to earn excess return over the risk-free rate.

Beta

A measure of a fund's sensitivity to market movements. The beta of the market is 1.00 by definition. A beta of 1.10 shows that the fund has performed 10% better than its benchmark index in up markets and 10% worse in down markets, assuming all other factors remain constant.

R-squared

An R-squared of 100 indicates that a fund's movements are perfectly correlated with its benchmark. Thus index funds that invest only in S&P 500 index stocks typically could have an R-squared close to 100. Conversely, a low R-squared indicates that little of the fund's movements can be explained by movements in its benchmark index. An R-squared measure of 35, for example, means that only 35% of the fund's movements can be explained by movements in the benchmark index. R-squared can be used to ascertain the significance of a particular Beta. Generally, a higher R-squared will indicate a more reliable Beta. If the R-squared is lower, then the beta is less relevant to the fund's performance.

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I simply thought that awareness of these concepts/definitions might help you a little, especially when considering the historic volatility and risk experienced by a professionally-managed investment fund i.e. like most of us might well hold in our Personal Pensions or SIPPs (Self-Invested Personal Pension).

Until next time…

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