Return is directly correlated with risk. This means that the more profit the investor wants to receive, the more risky financial instruments he will have to use. But blindly taking risks is stupid – you need to try to reduce it. The most reliable way to do this is to find a combination of assets that can achieve the optimal ratio of risk and return.
Let’s take a look at the 5 most relevant metrics to determine your desired risk/reward ratio. These parameters can be obtained using most services designed to compile securities and investment portfolio analytics. For example, they can be found using the Portfolio Visualizer site.
Average annual return
Average annual return is a metric that is obtained by adding up all the amounts of dividends or income and further dividing the resulting amount by the duration of holding this financial instrument. For example, if an investor holds shares in his account that pay dividends every year, then you need to sum up all income during this time and divide the result by five years.
The average annual return is especially useful for investing money in those financial instruments, the rate of which varies. A typical example of such investments is deposits, stocks, goods, real estate.
This measurement method is called retrospective. This means that it is used to determine the real outcome of the combination of different financial instruments in a portfolio or for an individual stock. That is, he seems to be looking into the past and taking it into account. Of course, a successful investment in the past does not guarantee an equally successful investment in the future. However, this metric allows you to evaluate how the portfolio has behaved in the past and what patterns are currently operating.
For example, if a savings bank account pays floating interest on balances, then the average return is obtained as follows – adding up all interest payments for the year and dividing the number by the average balance for that period.
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Geometric mean yield
In the case of a portfolio, no special formulas are needed to obtain this indicator. It is necessary to know the starting amount of the investment, the final capital, as well as the period of time during which the investment was made. Unlike the standard variant of the average annual return on a share, this variant also takes into account compound interest. Therefore, it allows you to more realistically assess the prospects for investing in a particular set of tools.
This statistic is used to determine the degree of investment portfolio volatility. It is derived from another indicator – dispersion, which is the spread of returns from its average value. The risk is directly related to the standard deviation. Conservative instruments do not change so that quotes go far away from the average value on the chart, while this is more typical for aggressive instruments.
An example of an investment instrument that is characterized by a large average deviation is Bitcoin. This is a very volatile asset, trading with high risk. Monthly prices can change a lot. So, on August 15, 2021, bitcoin cost $46,732 apiece. Then it grew, fluctuating within 2 thousand dollars. Then, on the first of September, after a significant correction (from $48,642 to $46,948), it rose sharply to $51,980 apiece. Having actually reached the psychological mark, its rate during the week fell sharply to $45,125 apiece, which is less compared to the beginning of this month-long period.
This is a typical example of volatility. And this happens to cryptocurrencies all the time, so novice investors are not recommended to invest their funds here if it is considered as an investment, and not some kind of gambling with high risk and a potential return of 6 thousand dollars from one bitcoin in a few weeks (11% for 3 weeks), but also with the same probability of getting a loss of a comparable size in an even shorter period.
A necessary metric that allows you to understand how reasonable it is to invest in a portfolio with a certain set of financial instruments. To determine it, you must use the following formula.
Portfolio Return − Risk Free Interest Rate) / Standard Deviation
The coefficient is interpreted as follows: the higher it is, the more profit an investor can derive per unit of risk. Accordingly, the higher it is, the more profitable a particular investment is expected to be.
How to measure investment risk?
There are a lot of measurement methods. For a beginner, professional analytics is not bad. Of course, here you need to remember that the ultimate responsibility for the financial result lies only with the trader himself. However, a company’s place in the ranking can tell a lot about the degree of risk of investing in it. Especially if the data is the same in different sources. There are also a number of other methods for determining the risk of an investment.
Issuers of some financial instruments sometimes indicate the level of risk. For example, ETFs that can be purchased on the Moscow Exchange operate under European law. This means that the marking ranges from 1 to 7.7, where the higher the value, the greater the risk of the investment.
An example is the FXRL fund, in which it is not recommended to invest money for beginners, as well as experienced professionals without a reliable diversification of investments.
But investing in a money market fund is safe, since the value is only 1. This suggests that after a certain time, FXMM shares will cost approximately the same as at the time of purchase: their value does not fundamentally change. Of course, there will not be large incomes here, but the risk of losing funds is certainly minimal. True, it must be borne in mind that even the most low-risk stocks or funds are still associated with a certain probability of losing funds.
The American exchange also has similar marking systems. There, the risk index can range from zero to 1000. The higher the number, the less it is recommended to invest in this tool.
How to determine the return on investment?
For this, a simple formula is used: Profit / Investments * 100%. True, in reality this is an overly simplified method of calculation, since all kinds of commissions, dividends, and additional fees affect the final profitability. There may also be different conditions for a particular investment instrument. For example, some deposits provide for a variable rate depending on how long a person holds money with him. If he keeps the funds with him longer, then the interest receives more.
Therefore, the real formula for determining the return on investment will be as follows:
Profit = Profit and loss per trade + Dividends − Commissions
Yield must be determined according to the above formula, where profit is formed from each transaction, dividends and commissions. If there are other factors, they should also be included in the formula.
Ultimately, you need to remember to translate everything into annual percentages. If the yield was calculated for the month, it is necessary to make sure that it is determined for the year. True, such an extrapolation is not always suitable, but this is another topic for discussion.