Best risk management methods for long-term investments: The Bottom line, Sharpe ratio, Beta, VaR, R-squared

If you are a long-term investor, one risk you face is the failure of your investments to generate the desired investment return. Investment risk is the possibility of sustaining negative returns in the short-term and medium-term, and can also include under-par positive returns in the longer term. Your long-term investment should help you achieve your long-term objectives. Apart from investment growth, it can also include generating an income stream and meeting long-term needs like pension and insurance. 

Risk measurement helps people in making wiser investment decisions and also adjust their investment portfolios in a timely manner. It helps you identify the risk and return attached to your investment. Based on your risk appetite, you can either accept the risk or mitigate it by reshuffling your portfolio. 

Risk management in investing involves a few important statistical checks and risk measurement methods, which gives a more scientific approach to your investments. These methods and approaches can demystify how to invest money in the most calculated manner.

Also Read: How To Evaluate Country-Specific Risks When Investing In International Markets?

• The Bottom Line

As a ‘sense check’, you should look at the bottom line of the investment you are putting your money into. This includes crunching numbers such as the net income, net profit, and earnings per share of the company. While the top line may indicate a high turnover, the company’s bottom line performance eventually affects your earnings - and, therefore, your investment decisions.

• Standard Deviation

The volatility of an investment is a key factor in your investment decision. If you are investing in a stock, you must take a look at its standard deviation. Standard deviation indicates the dispersion of data from the expected value. A higher standard deviation indicates that the stock swings sharply from its expected normal movements. So, a higher standard deviation indicates higher movement and thereby higher risk for the investor.

• Sharpe Ratio

Sharpe ratio gives a clearer picture of the expected return from your investment. It depicts the risk-adjusted return of the investment after eliminating the risk-free rate of return from the asset. Risk-free returns can be the return from (say) a fixed deposit or a government bond. So, if you are investing in an equity mutual fund, the Sharpe ratio helps you identify the extra risk you are taking to earn the incremental return.

Also Read: Risks You Must Watch Out For While Investing

• R-squared

The R-squared parameter can help you select the ideal mutual fund investment for your portfolio. But it can also be used to compare a long term investment with a benchmark. Using the RBI interest rate as a benchmark, you can check the R-square of any investment securities, fixed deposits, or government bonds. The closer the correlation of the bond to the RBI interest rate, the higher is its R-square. Similarly, if your mutual fund has a high correlation to the index fund, it will have a high R-square. If you are paying a high expense ratio for one such fund, it is time to reconsider. Because of all the expertise of the fund manager, the fund is more or less replicating the index and not outperforming it. 

• Beta

By considering that the stock market or a particular stock index has a beta of 1, you can find out the relative volatility of a stock. If the stock is more volatile, its beta will be more than one. Contrarily, in the case of less volatile stocks or investments, the beta will be less than one. So, if your stock has a beta of 1.2, the stock is 20% more volatile than the stock market as a whole. 

• Value at Risk (VaR)

VaR is useful in managing the risk of your investment portfolio as a whole. For a specified time period, the VaR is the maximum possible loss that the portfolio can incur with a degree of confidence. If your investment has a 5% VaR of Rs 10 lakh in one year, it means there is a 10% possibility that your investment will lose Rs 10 lakh or more in a single year. 

Also Read: 6 Practical Strategies To Help Reduce Investment Risk

Last words

If you are wondering how to measure risk on your long-term investments, these methods will help you find the best way to invest money. You cannot change the fact that, inevitably, investment involves some degree of risk. Therefore, when you are building your portfolio to meet your long-term financial objectives, make sure that your investments meet your preferred risk parameters.