One of the principles of investments, risk-return, defined as the ratio between the risk level and the level of potential profit. For most stocks, bonds and mutual funds, investors know taking the higher risk, or volatility results in greater potential returns. To determine the risk and profitability of a particular investment Fund, the investors analyze the investment alpha, beta, standard deviation, and the Sharpe ratio. Each of these indicators is usually provided by the mutual Fund company offering investment.
Mutual Fund Alpha
Alpha is used as measure of profitability of mutual funds compared to a particular benchmark, adjusted for risk. For most stock mutual funds the index used to calculate alpha S&P 500 index, and any amount of risk-adjusted return of the Fund above the performance benchmark is considered to be his alpha. A positive alpha of 1 means that the Fund exceeded the benchmark by 1% while a negative alpha Fund worse. The higher alpha, the more potential income with this particular mutual Fund.
Beta Mutual Fund
Another measure of risk-reward compromise is the mutual Fund beta. This indicator calculates the volatility when the price moves against the market index such as the s&P 500. A mutual Fund with a beta of 1 indicates its underlying investments, to move in accordance with the standard of comparison. Beta above 1 results in investment that has higher volatility than the benchmark, while a negative beta means that a mutual Fund may have fewer fluctuations over time. Conservative investors prefer low beta, and are often willing to accept lower returns in exchange for less volatility. (For associated reading, see: alpha and beta for beginners.)
The Standard Deviation
In addition to alpha and beta, the mutual Fund company provides investors with the calculation of the standard Fund deviation to show the variability and the principle of risk-return ratio. Standard deviation measures an investment’s return over time and compares it to the average return of the Fund over the same period. This calculation is often done using the closing price of the Fund each day over a period of time, e.g. one month or one quarter.
When every man returns regularly deviate from the average return of the Fund over this time period, the standard deviation is considered high. For example, a mutual Fund with a standard deviation of 17.5 has a higher volatility and more risk than a mutual Fund with a standard deviation of 11. Often, this rate is compared among funds with similar investment objectives to determine that has the potential for greater fluctuations over time.
The Sharpe Ratio
Risk-reward mutual Fund compromise can also be measured through the Sharpe ratio. This calculation compared the Fund’s performance with the implementation of a risk-free investment, often in three-month U.S. Treasury bills (t-bills). A high level of risk should lead to higher returns over time, so that the ratio is greater than 1 depicts a return that is greater than expected on the level of risk assumed. Similarly, a ratio of 1 means the yield of a mutual Fund relative to its risk, and the ratio less than 1 indicates the return was not justified by the number of received risk.
(For associated reading, see financial concepts: the risk/return.)