Understanding risk and using it for better returns

A lot is talked about returns that your investment will generate and not much attention is given to the risk part, which is equally important. Like returns that are calculated in different ways, risk measures to have their own shades. Determining which risk measure to use is primarily decided by the objectives and preferences of the investor. Although most risk measures are easy to calculate, they are not as easy to interpret and often present a conflicting picture. Therefore, it is important to calculate some risk measures that are consistent with your investment objectives and you can easily understand that.

There is another complexity involved while accessing the risk of an investment. Risks are primarily calculated in two fundamentally different ways, ex-post and ex-ante. Ex-post is also known as historical risk and is based on events that have occurred. It basically answers the question, how risky has the portfolio been in the past? On the other hand, ex-ante risk or prospective risk is forward-looking, based on a snapshot of the current securities and instruments within the portfolio; it is an estimate or forecast of the future risk of the portfolio.
Many a time there can be a substantial difference between ex-post and ex-ante risk calculation, which will help you to give better guidance on the risk.

Some of the most important risk measures used in mutual funds are:

Variability: It is variability (or dispersion) of returns from the average or means return.
Mean absolute deviation: There is a slight variation with how the variability is calculated and the absolute difference is used without considering the sign while calculating mean absolute deviation.
Variance: The variance of returns is the average squared deviation of returns from the mean return.
Standard deviation: For analysis, it is more convenient to use our original non-squared units of return; therefore, we take the square root of the variance to obtain the standard deviation.

More than that, it is essential to monitor changes over time in both the ex-ante and ex-post tracking errors. The risk efficiency ratio compares realised risk with forecast risk–ideally we would like the ratio to be 1 indicating that our forecasting tools were efficient. If the ratio is much greater than 1 then we are aware that our forecasting tool is underestimating relative risk.

These ratios in itself will not reveal much until it is compared with ratios of other similar investments over the same time frame with similar features. Hence, it is important to take this risk measures along with other investment objectives