Is the risk you carry the risk you want to have?

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Standard deviation is the most commonly used risk indicator in finance. But more important than the risk indicator itself is how you use the indicator. The understanding of risk indicator usage in portfolio management could be better, and in this blogging I will tell you how.

Portfolios and funds with low standard deviation are more stable performers. Let’s use an example where we have two funds which you can think as any portfolio. Take Fund A, which gives historical returns of 5% p.a. with a standard deviation of 10%, while Fund B returns 7% p.a. and carries a standard deviation of 20%. Although Fund B has generated greater returns than Fund A, it carries greater risk than fund A, since its standard deviation is double when comparing to Fund A.

A standard deviation of 20% means that Fund B has the potential to earn 20% more than the expected return, but is likely to earn 20% less than the expected return.

The use of standard deviation to gauge risk has its drawbacks as well. First, standard deviation will come out to be zero in case a mutual fund has yielded a uniform return (positive and negative) during the period for which it is being calculated. Second, standard deviation lacks intuitiveness. What you get to know is that a standard deviation of 20% is higher than 10% but the context is lacking. You might as well compare apples against oranges.

 
You might as well compare apples against oranges.

 

One option is to compare a suitable benchmark A with the Fund A to give you an idea of its performance and risk, vis-a-vis others. Actually the importance of rebalancing a portfolio with its benchmark is crucial. When you select new funds to your investment portfolio or adjust your investment strategy, you should consider rebalancing your portfolio in order to control the risk as well. You compare returns and risk generated by your asset with benchmark and see if the risk you carry is the risk you want to have.

 

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