Nine Questions About Investment Risk
During the five-year ascent from the trough of the 2000-2002 bear market to the market peak of October 2007, there seemed scant reason to worry about investment risk. But the market downturn brought about by the credit crunch and weakened economy has driven home the fact that the concept of risk is ignored at an investor's peril.
So how much do you know about measuring risk? Here is a nine-question investment quiz to test -- and possibly enhance -- your knowledge of the concepts of investment risk.
Feel free to use the many features available on TheStreet.com to help you answer the questions. A great place to start your quest is the "Search" box at the top of TheStreet.com.
Another great resource available on our Website is a glossary of definitions and explanations of financial and investment terms. Just roll-over the "Portfolio Tools" tab at the top of the site and select "Glossary" (or simply click here).This investment trivia quiz is a self-test, so keep your own score. Ready? Good luck! Question 1: What is the most basic measurement of investment risk? Basic measure of risk can be applied to any number of different types of investments, such as individual stocks and bonds, a group of stocks, a combination of bonds, or a diversified portfolio of stocks and bonds. When you have identified the most basic measurement of investment risk, what is the logic in using this measure and what do the values represent? Question 2: What is a "Sharpe ratio" (and who is William F. Sharpe, after whom the gauge is named)? This relates to the first question, but moves things in a direction of more interest to ordinary investors. Understanding the Sharpe ratio might get you to look at your investments a bit differently. Question 3: If an investor is considering two stocks with exactly the same projected rates of return and identical standard deviations of returns, under what condition would it make sense to hold both of them rather than just one? The answer to this can add new dimensions to your approach to portfolio construction. Question 4: What does "drawdown" mean and in what markets is it most commonly used as a measure of risk? A huge amount changes hands daily in markets where drawdown is a common risk metric. How do these markets impact the lives of ordinary people? Question 5: What is the most common risk measurement for fixed-income investments ? An interesting measure is used to gauge the risk of fixed-income investments like bonds. But the more you get into the measurements of bond risks, the greater will be your appreciation that fixed-income investments are a lot more complex than you might have thought. The answer to this will contain some bonus information for those who are really into math. Question 6: Is cash -- stored in a completely theft-proof, climate-resistant vault -- the least risky investment? Economists and scholars who study risk have thoughts about the above the concept of risk-free "savings" that might surprise you. If cash stored in a completely secure vault isn't totally risk-free, then what is -- at least in the minds of those who study the subject of risk? Question 7: What is "modern portfolio theory," the "beta coefficient," and what do they have to do with the measurement of investment risk? This really gets you into the theory of risk. But a basic understanding of the principles behind "MPT" can help refine your approach to investing. Question 8: What is the "alpha coefficient" and what is its significance? There are mutual funds with names like Alpha Hedged Strategies (APHCX), GMO Alpha Only III (GGHEX) and Nuveen Symphony Optimized Alpha (NOPAX). What do the references to alpha in their names mean? Investment professionals will sometimes describe a manager as "someone who consistently achieves positive alphas." What is so important about the alpha coefficient? Question 9: What is the equation for determining the beta coefficient of a mutual fund, given its monthly returns? This one is likely to challenge anyone who breezed through all the preceding questions. If you now have a conceptual knowledge of investment risk measures, you are in good shape -- even without knowing the underlying equations. But math freaks who want to know "how the engine works" will want to try this one. Your answer should include detailed descriptions of all the variables in the equation. Ready for the answers to questions one through nine?
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