Which Provides a Better Measure of Risk?
Risk – it is a chance or a possibility that the actual cash flows or returns from an investment will be less than what has been forecasted. Losing one’s capital or all original investments is the biggest risk an investor has to face. Trying to avoid this scenario, as much as possible, the investing world produces two popular ways on how risk can be measured.
The standard deviation is widely used technique for measuring risk. Together with the mean, which is the average that can state where the center of distribution is, you can measure the variations of specific returns. The standard deviation’s significance is to show how much data is distributed around the mean and the quantification of the broadness of the distribution. This is commonly used for those assets stated as percentages. However, its constant dependence on movements around the average and its assumption of a normal probability distribution produces flaws. That is where a relative measurement of risk might be helpful and meaningful. Dividing the standard deviation by the average return is commonly called the coefficient of variation, which is generally used for those assets stated in dollars (Hee Kim 401). Still, one must note that this process of measuring risk is useless unless it is to be compared relative to other investments. The risk can be measured upon the relationship of the values of two or more variables. The coefficient of variation can measure the dispersion of two different data series from their respective expected returns, and therefore their relative risk (Cayon Fallon & Sarmiento 2).
All in all, one can determine which way provides a better measure of risk by first analyzing the data he acquired. If one assumes a normal probability distribution, that is, if one has investments that are approximately equal in size and the expected returns are the same, he can use standard deviation to assess the probability of an event occurring while in comparing investments with different expected returns, the coefficient of variation offers a better measure of risk.
Cayon Fallon, Edgardo and Sarmiento, Julio Alejandro, Is Historical VaR a Reliable Tool for Relative Risk Measurement in the Colombian Stock Market?: An Empirical Analysis Using the Coefficient of Variation (11 December 2003). Available at SSRN: <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=478718>
Kim, Seung H., Kim, Suk H., and Kim, Kenneth A. Global Corporate Finance: Text and Cases. United Kingdom: Blackwell Publishing, 2006
“Returns and Risk.” University of North Florida. Retrieved 11 November 2008, from <http://www.unf.edu/~cfrohlic/4504c6.doc>