07 October 2022

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Calculate the risk

Luigi Campopiano

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How do you see the financial markets shortly? And what about gold? And the crypto? 

Markets are unpredictable in the short term, but they will rise in the long term, and crypto is more fun than making an actual investment. But you might also know someone close to you that has earned 15% that way. 

That 15% does not mean anything and is not necessarily a good result. If you want to know if the money is invested correctly, stopping at the yield without asking more questions is not good. When evaluating your investments, the first thing to do is to understand if the risk you are subjected to has been adequately rewarded or if you have risked too much compared to the money you took home. Understanding this is not as difficult as it sounds. 

The best way is to look for a benchmark, or reference index, that approximates the portfolio's risk, ideally to be decided at the beginning of the strategy itself. In a nutshell, you need a term of comparison to evaluate the choices: if the portfolio is 100% equity, it cannot be compared with the yield of a government bond or bond in general (apples with apples and pears with pears). 

If you choose 10 apples out of a basket of 100 apples where 60 are good and 40 rotten, it is not enough to say that more than half of the apples chosen were good. You must end up with at least seven good apples. If the percentage of good apples is the same as in the basket, no value has been added; you have been lucky enough to have a good basket. Comparing your own performance to a benchmark means evaluating if your basket is better than the large basket from which you selected your apples. However, the game is not over. 

There is another fundamental variable that must be considered: risk. To know if your investments have worked well, it is crucial to understand whether the return obtained is adequate for the risk taken. For example, you would risk losing 50% of your capital with the prospect of earning 3%. That is likely not a risk most people would take.  

To calculate the risk, it is enough to rely on volatility, or the dispersion of the future returns of your portfolio. To simplify: Volatility of 15% translates into a possible return equal to + or- twice the volatility, therefore to about + or - 30%. 

Now that we have explored the concept of risk as volatility, we can now calculate that of a portfolio concerning the benchmark. To compare the two investments, it is necessary to calculate the return per unit of risk — performance divided by volatility. This parameter is called the Sharpe ratio, the ratio between return and risk. If I obtained a 10% return by supporting a 10% risk, my ratio would be 10/10, which is 1. The shape is variable, like the returns of the markets. In the long term, a shape is estimated for many investments of about 0.4. 

Now we can say with certainty that, before saying, "I made 15%,” we must ask ourselves important questions. Otherwise, we are not sure that our investments are adequately remunerated.