In essence, volatility is a measure of the uncertainty of an investment. Fund fact sheets and performance analysis often use volatility measures to indicate the investment risks. Among the most common are alpha, beta, r-squared, standard deviation and the Sharpe ratio.
These statistical measures use historical data of volatility. They are major components of Modern Portfolio Theory (MPT). The MPT is a standard financial and academic methodology used for assessing the performance of equity, fixed-income and mutual fund investments by comparing them to market benchmarks. These risk measurements are intended to help investors determine the risk-reward parameters of their investments.
Alpha
Alpha is a measure of an investment's performance on a risk-adjusted basis. It takes the volatility (price risk) of a security or mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the investment relative to the return of the benchmark index is its "alpha". Simply stated, alpha is often considered to represent the value that a portfolio manager adds or subtracts from a fund portfolio's return. A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%. For investors, the more positive an alpha is, the better it is.
Beta
Beta, also known as the "beta coefficient," is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is calculated using regression analysis, and you can think of it as the tendency of an investment's return to respond to swings in the market. By definition, the market has a beta of 1.0. Individual security and portfolio values are measured according to how they deviate from the market.
A beta of 1.0 indicates that the investment's price will move in lock-step with the market. A beta of less than 1.0 indicates that the investment will be less volatile than the market, and, correspondingly, a beta of more than 1.0 indicates that the investment's price will be more volatile than the market. For example, if a fund portfolio's beta is 1.2, it's theoretically 20% more volatile than the market.
Conservative investors looking to preserve capital should focus on securities and fund portfolios with low betas, whereas those investors willing to take on more risk in search of higher returns should look for high beta investments.
R-Squared
R-Squared is a statistical measure that represents the percentage of a fund portfolio's or security's movements that can be explained by movements in a benchmark index. For fixed-income securities and their corresponding mutual funds, the benchmark could be the government bills and, likewise with equities and equity funds, the benchmark could be the Nifty index.
R-squared values range from 0 to 100. According to Morningstar, a mutual fund with an R-squared value between 85 and 100 has a performance record that is closely correlated to the index. A fund rated 70 or less would not perform like the index.
Standard Deviation
Standard deviation measures the dispersion of data from its mean. In plain English, the more that data is spread apart, the higher the difference is from the norm. In finance, standard deviation is applied to the annual rate of return of an investment to measure its volatility (risk). A volatile stock would have a high standard deviation. With mutual funds, the standard deviation tells us how much the return on a fund is deviating from the expected returns based on its historical performance.
Sharpe Ratio
Developed by Nobel laureate economist William Sharpe, this ratio measures risk-adjusted performance. It is calculated by subtracting the risk-free rate of return (government bonds) from the rate of return for an investment and dividing the result by the investment's standard deviation of its return.
The Sharpe ratio tells investors whether an investment's returns are due to smart investment decisions or the result of excess risk. This measurement is very useful because although one portfolio or security can reap higher returns than its peers, it is a good investment only if those higher returns do not come with too much additional risk. The greater an investment's Sharpe ratio, the better its risk-adjusted performance.
Besides these five measures, there are a few others which can be used to measure volatility:
Treynor Ratio
Also known as reward-to-volatility ratio, Treynor Ratio measures returns earned in excess of that which could have been earned on a riskless investment per each unit of market risk.
Sortino Ratio
The Sortino Ratio measures the risk-adjusted return of an investment asset, portfolio or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target or required rate of return while the Sharpe ratio penalizes both upside and downside volatility equally. It is thus a measure of risk-adjusted returns that treats risk more realistically than the Sharpe ratio.
Downdside Deviation
A measure of downside risk that focuses on returns that fall below a minimum threshold or minimum acceptable return (MAR).
Standard deviation, the most widely used measure of investment risk, has some limitations such as the fact that it treats all deviations from the average - whether positive or negative - as the same. However, investors are generally more concerned with negative divergences than positive ones, i.e. downside risk is a bigger concern. Downside deviation resolves this issue by focusing only on downside risk. Another advantage over standard deviation is that downside deviation can also be tailored to the specific objectives and risk profile of different investors who have various levels of minimum acceptable return.
Tracking error
A divergence between the price behaviour of a portfolio and the price behaviour of a benchmark. This is often in the context of mutual fund that did not work as effectively as intended, creating an unexpected profit or loss instead.
Information Ratio
It is a measure of the risk-adjusted return of a financial security (or asset or portfolio). It is defined as expected active return divided by tracking error, where active return is the difference between the return of the security and the return of a selected benchmark index, and tracking error is the standard deviation of the active return.
The information ratio is often used to guage the skill of managers of mutual funds, hedge funds, etc. In this case, it measures the expected active return of the manager's portfolio divided by the amount of risk that the manager takes relative to the benchmark. The higher the information ratio, the higher the active return of the portfolio, given the amount of risk taken, and the better the manager.