There is an old proverb that states, “what is fit for everything cannot fit anything well.” Such logic applies to many areas of our everyday lives. One area within retirement plan investment is the consideration of risk measures. While some general risk measures are well known to the investing public, popularity is not an indicator of “best fit.”
Investment professionals need to consider the role of a given strategy within a portfolio and define risk appropriately.
Key Types of Investment Risk Measures
Volatility, or an investment’s up-and-down return stream, is a common way to describe investment risk. Standard deviation measures how widely returns vary from the average. Larger swings mean higher volatility and higher risk. Imagine investment returns as a bell curve. Most results, such as average monthly returns, cluster near the middle, while extreme gains or losses appear at the thinner ends. The curve can tilt to one side, called skewness, or appear taller and narrower, or flatter and wider, which is called kurtosis. These patterns help analysts see whether returns tend to produce more significant losses or gains than a typical pattern would suggest.
Standard deviation can be useful for some investments, but it does not tell the whole story for every type of investment. Less volatile investments, such as bonds or stable value funds, often have very low standard deviations. Those numbers can look almost the same, even when the actual risk of the strategies differs. Standard deviation alone may not clearly show differences in risk between similar low-volatility investments.
Other risk measures focus on downside protection, showing how much an investment can lose, not just how much it moves. Metrics such as maximum drawdown, downside deviation, and semi-standard deviation provide insight. Maximum drawdown shows the worst peak-to-bottom decline over a period. Downside deviation and semi-standard deviation examine only the negative side of the bell curve – periods when returns are negative. In short, standard deviation accounts for all ups and downs, while downside-focused measures capture the volatility of losses, which is often the main concern for investors.
How Different Measures Capture Market and Manager Risk
Different measures help describe risks that come from the overall market and the manager’s decisions.
- Beta shows how sensitive a strategy is to market moves, whether it tends to move more or less than the market.
- Capture ratios compare how much of the market’s gains a strategy earns in good (bull) markets and how much of the losses it experiences in bad (bear) markets.
- Alpha estimates the value a manager adds (or fails to add) through active decisions, after accounting for overall market movements.
- Tracking error shows how closely a strategy’s returns track its benchmark, or how far they deviate from it over time
Risk‑adjusted ratios, such as the Sharpe ratio, Treynor ratio, and information ratio, show how much value a strategy has added relative to the risk taken. They all follow a similar idea: take the return above a benchmark (for example, how much more the strategy earned than cash or a market index, etc.) and divide it by some measure of risk.
- The Sharpe ratio compares this extra return to overall volatility (standard deviation).
- The Treynor ratio compares this extra return to market risk (beta).
- The information ratio compares the extra return to the strategy’s tracking error (the extent to which its returns differ from its benchmark).
Many other risk‑adjusted ratios exist, but all work by comparing returns to a chosen measure of risk.
There is no universal risk metric that fits all types of investments. Given the variety of risk measurement approaches, careful consideration is needed to determine the appropriate metric. Investors and plan sponsors should understand the lens through which risk is being measured.
How CBIZ Approaches Risk
CBIZ has developed a unique investment-scoring method that uses appropriate risk measures for each asset class, based on its role in the overall portfolio. Each asset class uses a unique set of metrics to derive its overall score, enabling risk to be measured more appropriately.
For equity managers
We use metrics such as portfolio concentration and the information ratio to assess whether investors are being paid fairly for taking on different risks than the market or peer group. Portfolio concentration shows how much of the fund is invested in its largest stock positions – for example, if one company makes up 10% of the portfolio rather than spreading money more evenly across many stocks. We believe stock funds should be the main growth engine in a participant’s portfolio, so the risk tied to individual stocks matters more here, in addition to the general market and downside risk that all stock strategies share.
For fixed-income managers
We use maximum drawdown to assess how well they have acted as a “ballast” in rough markets. Because bonds are expected to help protect the portfolio when stocks fall, it is especially important to understand how much they can lose in stressed environments. Smaller drawdowns are one way to see whether a strategy has historically offered meaningful downside protection.
For index or passive investments
Our focus is on tracking error. Index managers are not trying to beat the benchmark or deviate from it, so their market risk and volatility should closely match those of the index. Low tracking error values give confidence that the manager is staying close to the benchmark, in line with what investors expect from a passive strategy.
For target-date and allocation funds
We look at the Treynor ratio and standard deviation to assess how well the manager allocates across asset classes. Asset-mix decisions are the main driver of long-term return differences across these multi-asset portfolios.
Explore Your Plan’s Investment Strategy With CBIZ
Contact CBIZ today to discuss your investment strategy with our team of advisors.
The information included in this article is provided for informational purposes only and should not be construed as investment advice. Investment advisory services provided through CBIZ Investment Advisory Services, LLC, a registered investment adviser and a wholly owned subsidiary of CBIZ, Inc.
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