Investors today have access to more data and tools than ever, yet many still experience anxiety when it comes to investing. Part of this anxiety may stem from a misunderstanding of risk and reward, which makes it difficult to know what to expect from your investment. The first step to tackling this issue is knowing the best way to measure risk.

To gain a more accurate understanding of risk, it's important to recognize the strengths and weaknesses of popular metrics. Risk metrics that account for the frequency, depth, duration and recovery time of loss can be more meaningful than some of the common metrics used today, and offer a better idea of what to expect regarding returns.

1

Know the Limitations of the Sharpe Ratio

This common measurement tool for assessing risk and return is based on the belief that broad risk is measured by volatility. But volatility is not the same as loss, and thus not always an accurate way to represent risk. The Sharpe Ratio also assumes return normality, fails to capture the frequency and depth of declines, and does not account for illiquidity—pitfalls that are most apparent when assessing hedge funds.

2

Utilize Investment Capture

Investment capture is an approach that incorporates both risk and reward into the same metric by setting up an ideal target range for returns. It is a useful strategy in building an entire portfolio, or assessing an individual manager or asset class. Incorporating the potential for loss, while setting targets for gains, better prepares the investor for what to expect.

3

Incorporate Drawdown-Based Metrics

Drawdown measures the peak-to-trough decline in an investment and the time period between each peak. Drawdown-based metrics, such as the Pain Index, Calmar Ratio, Omega Ratio and Conditional Value at Risk (CVaR), more accurately capture the investor experience by assessing risk in terms of actual loss and recovery from that loss, as opposed to volatility.

“Without a firm grasp of the risk of an investment, it can be difficult, if not impossible, to set appropriate expectations for the investor in terms of return and potential loss.”
A better understanding of risk can help investors better prepare for what lies ahead for their portfolios
Remember there are two sides to volatility

Volatility focuses on price variation compared to the investment's average return and the market as a whole. This is not the same as a loss — in a rising market, high volatility can mean higher returns.

Understand the makeup of a portfolio

If a portfolio contains asset classes beyond those in the traditional 60/40 stock and bond portfolio, it's even more important to use these alternative metrics.

Set the right expectations

To prepare for the market's ups and downs, investors must consider how much loss they are willing to accept as they seek an ideal return.

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