Many investors find mutual funds an attractive option for assets to add to their portfolio. Mutual funds allow you to obtain instant diversification since when you are buying a share in a mutual fund you are investing in a large number of assets. However, when making investment decisions, you will need to weigh the risk versus potential reward of a particular asset you are considering adding to your investment portfolio. According to modern portfolio theory, there are five ways to measure risk of a mutual fund: alpha, beta, r-squared, standard deviation and the Sharpe ratio.
Alpha
Designed to measure asset performance on a risk-adjusted basis, alpha compares the price risk of the asset to the return of a specified benchmark index. The asset’s excess return compared to the risk-adjusted return of the index is the alpha of the specific asset you may be looking to invest in.
For instance, an alpha of 2.0 indicates the asset outperformed the particular benchmark index by 2%. On the other hand, an alpha of -2.0 means the asset underperformed the benchmark by 2%.
Beta
Also referred to as the beta coefficient, beta measures the volatility of a mutual fund portfolio or some other investment asset compared to the overall market. The beta of the specific market index is 1.0. The beta of the asset you are analyzing is how much more volatile its price movements are compared to the benchmark. A beta of less than 1.0 indicates volatility that is less than the benchmark while a beta of more than 1.0 would mean the asset is more volatile than the benchmark index.
R-squared
This is a measurement of how correlated a mutual fund portfolio or other asset is with a specific market index. R-squared measurements range from 0 to 100 with the higher value indicating a higher level of correlation with the benchmark. Generally, it may be a good idea to avoid actively managed mutual funds with higher R-squared values since it may not be worth the management fees charged to see returns similar to a passive index fund.
Standard deviation
An asset’s standard deviation is another measurement of its volatility. Standard deviation allows you to determine how much return a fund or asset is currently deviating from expectations based upon historical price data. Financial professionals will measure standard deviation based upon annual rates of return.
Sharpe ratio
Another risk-adjusted measurement of asset performance, created by Nobel laureate economist William Sharpe, is known as the Sharpe ratio. This measurement is calculated first by taking the rate of return of a U.S. Treasury Bond, considered practically a zero-risk asset, from the rate of return of the asset or fund you are analyzing. You would then take the result of that calculation and divide it by the standard deviation of the asset being analyzed. The higher the Sharpe ratio value, the stronger the asset’s performance is on a risk-adjusted basis.
How much is too much risk for a mutual fund?
It really does depend on the individual when it comes to how much risk is acceptable when looking to invest in a mutual fund. Some investors who may be older in age might want to take little risk, while younger investors may be at a point in their lives where they have a higher risk tolerance. What you have in your existing investment portfolio as well as various other personal finance aspects should also be taken into consideration.
Opinions expressed in the attached article are those of the author and are not necessarily those of Raymond James. All opinions are as of this date and are subject to change without notice. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. The forgoing is not a recommendation to buy or sell any individual security or any combination of securities. Be sure to contact a qualified professional regarding your particular situation before making any investment or withdrawal decision.