Have you ever thought about investing some of your earnings in different assets? If you haven’t, then you should. After all, investing your money today can help reap benefits in later years.
The first step in investing is to have some amount of money that you won’t be needing for your day-to-day expense. This is the extra cash that you can put away to earn profits.
According to Financially Simple, those who wait till a later age to start saving money have to save more for sufficient returns. To put things into perspective, those who begin saving money at the age of 45 must make thrice more effort than those who begin saving at 25.
Once you have the resources, it is time to decide which financial instrument you wish to invest in. According to research conducted by Forbes, over 66 percent of young adults find the stock market an intimidating instrument to invest in compared to 57 percent of 55-year-olds who share the same sentiments.
Rather than deciding how to invest based on your hunches, it is much better to quantify the investment risk involved in each instrument. Investment risk refers to the chances of losing your money in a given instrument. Generally, the higher the risk, the higher is the return or interest charged.
Here are ways that can help you can quantify the risk involved before making your first investment:
- Using Alpha and Beta Ratios
Two statistical metrics can be effectively used to quantify investment risk. These are alpha and beta ratios. These risk ratios are handy in determining the level of risk and return your investment can provide.
Alpha is a statistical metric that compares the performance of a given portfolio to the benchmark. The benchmark index can be set according to the instrument in question. For instance, in some cases, the S&P 500 is taken as a standard for comparison against the performance of the portfolio.
The alpha value is calculated as the difference between returns generated from the investment in question compared to the benchmark’s average return.
Let’s say that the alpha value of a given security is positive. It means that the given investment is performing better than the standard. On the other end, a negative value means that the investment is underperforming.
Another metric used to analyze investment risk is the beta value. Beta measures how volatile a portfolio is when compared to the benchmark.
You might wonder how the beta value differs from the alpha value. Well, here, the fluctuation in the asset prices are monitored rather than its overall performance. In case beta is positive, it means that the asset is more volatile than the standard stock. A beta value of one signifies a stable asset.
- Stock scoring system
If you want to invest in the stock market, then your biggest worry must be how to select the most suitable company from the thousands of companies listed on the stock exchange. In this case, you can take help from a stock rating system.
According to the portfolio analytics tool – Ziggma, a well-designed stock rating or scoring system, reflects companies’ relative economic performance and prospects and thus identifies the best companies to invest in.
Stock rating and scoring systems work by collecting companies’ financial data from the Securities and Exchange Commission’s filings and then analyze it to identify the best companies.
The companies are then allotted ranks from best to worst based on these analyses. The higher the rank of the company is, the more likely that the company’s stock will appreciate.
Financial companies have their own rating scales based on different metrics. However, today there are financial analytics tools that also provide these analyses.
- Using CAPM
Capital Asset Pricing Model (CAPM) is a theory that helps in the calculation of investment risk. This theory establishes a relationship between the expected return of an asset with the associated risk.
It makes use of the beta ratio in measuring risk. According to this theory, the beta coefficient should be linearly related to the total return expected from the asset. Therefore, the riskier the investment, the more premium it must get above the benchmark.
If you have the asset price and risk-free rate (which refers to the expected interest on the investment in a risk-free situation), you can easily calculate the beta coefficient, and hence the risk involved.
- Using The Sharpe Ratio
Compared to all other methods of quantifying risk involved in making investments, the use of the Sharpe Ratio is the most popular in the world of financial analysis.
The Sharpe ratio measures the additional return that is expected from a given investment relative to its volatility. The higher the expected return, the higher is the risk.
This is because the return that investors can get at a risk-free rate is the return that is the safest and most risk-averse. Anything added to it comes with the trade-off of risk and volatility.
A value above one is said to have a high risk-to-reward ratio. In other words, if the risk involved is high, the return of the investment will be just as high, making the investment lucrative.
- Using the VaR approach
For those of you looking for simpler ways to measure the risk attached to your first investment, you might want to make use of the Value at Risk (VaR) approach.
This method measures that maximum loss that can be incurred at a particular confidence level. The loss cannot go beyond the said value. This loss is calculated based on confidence level, period, and loss amount.
Therefore, it always presents you with the worst-case scenario. As a first-time investor, this will show you the mirror of what you can expect if it all goes wrong.
Let’s say a given investment has a VaR of 10 percent. It means that there is a 10 percent probability that you will end up losing the entire investment in a month.
You might have noticed that this method is not as comprehensive and specific as the other ones mentioned above. While it might not be as complex, it is still an excellent tool for beginners wishing to manage their portfolio effectively.
Regardless of which method you choose to quantify your investment risk, it is highly advised that you seek help from professionals belonging to the world of finance to understand the volatility of your investment better. If not, at least make use of portfolio management tools.
This is because, to a beginner, with no background in finance, some of the values and words might not make sense. But to a professional, they can be enough to paint a given instrument as a profitable or unprofitable investment.
Check out my guide on how to start your business right with tons of useful tips I learned by successfully starting, building, and selling multiple companies.