Measuring Investment Risk and Return: Tools Every Investor Should Know

In the world of investing, risk and return are two sides of the same coin. Every financial decision you make—whether it's investing in shares, buying property, or contributing to a pension—carries the potential for gain and the possibility of loss. To build wealth and make informed decisions, it's essential to understand how to assess both the expected rewards and the risks involved.

In this blog, we’ll explore the core tools and techniques used to measure investment risk and return, providing practical examples so you can start applying these concepts in your own financial journey.

Why Measuring Risk and Return Matters

Let’s say you’re deciding between two funds. One promises a potential annual return of 10%, the other 8%. The 10% return sounds better, but what if that fund has a history of sharp losses, while the other is much more stable? This is why measuring both return and risk is vital.

Return tells you what you might earn. Risk tells you what you might lose—and how frequently. Smart investors don't just chase the highest return. They look for the best return relative to the risk they are taking.

1. Expected Return: Planning for Likely Outcomes

Expected return is the average return an investment is likely to produce over time, based on probabilities or historical performance. It helps set realistic expectations, especially when comparing multiple investment options.

Basic formula:

Expected Return = (Probability of Outcome A × Return A) + (Probability of Outcome B × Return B) + ...

Example:

You’re analysing a tech stock with the following outlook:

• 50% chance of gaining 12%

• 30% chance of gaining 5%

• 20% chance of losing 10%

Expected Return = (0.5 × 12%) + (0.3 × 5%) + (0.2 × -10%) = 6% + 1.5% - 2% = 5.5%

This weighted average return provides a snapshot of how the investment might perform on average over time.

2. Standard Deviation: Measuring Volatility

Standard deviation measures how much an investment’s returns vary from its average return. It’s a widely used metric for volatility.

• A low standard deviation means returns are more predictable and stable

• A high standard deviation suggests greater uncertainty and potential for sharp losses or gains

Example:

If Investment A has an average annual return of 8% with a standard deviation of 3%, most yearly returns will fall between 5% and 11%. Investment B might have the same 8% return but a standard deviation of 10%, meaning annual returns could range from -2% to 18%.

Standard deviation helps you understand how smooth or bumpy your investment journey might be.

3. Sharpe Ratio: Evaluating Risk-Adjusted Returns

The Sharpe Ratio allows you to compare how much return you're getting for the level of risk you're taking. It considers the risk-free rate (like what you’d earn on a government bond) and standard deviation to tell you whether an investment’s returns are worth the volatility.

Formula:

Sharpe Ratio = (Return – Risk-Free Rate) / Standard Deviation

Example:

If Fund X returns 10%, the risk-free rate is 2%, and standard deviation is 12%, the Sharpe Ratio is: (10% - 2%) / 12% = 0.67

A Sharpe Ratio above 1 is generally considered good, while anything below 1 suggests the return may not justify the risk.

4. Beta: Understanding Market Sensitivity

Beta measures how much an investment moves in relation to the market.

• A beta of 1.0 means the investment tends to move in line with the market

• A beta greater than 1.0 means the investment is more volatile than the market

• A beta less than 1.0 means it is less volatile

Example:

A beta of 1.2 indicates the investment is 20% more volatile than the market. If the market rises by 5%, the investment might rise by 6%. But it could also fall harder if the market dips.

This measure helps you balance your portfolio between high-growth and more stable assets.

5. Maximum Drawdown: Preparing for Worst-Case Scenarios

Maximum drawdown refers to the largest percentage drop an investment has suffered from its peak value before recovering. It highlights the worst-case scenario for a given investment.

Example:

A fund rises to £100,000 and then drops to £70,000 before recovering. The maximum drawdown is: (£100,000 - £70,000) / £100,000 = 30%

This figure is useful for understanding how much you could lose in a downturn and how long recovery might take.

Applying These Tools in Practice

Let’s say you’re comparing two balanced investment funds:

• Fund A: 7% average return, standard deviation of 5%, Sharpe Ratio of 1.0, maximum drawdown of 15%

• Fund B: 9% average return, standard deviation of 10%, Sharpe Ratio of 0.7, maximum drawdown of 30%

Fund B offers a higher return but comes with greater risk. Fund A is more stable and delivers a better return for the risk taken. Depending on your risk tolerance and goals, one might suit you better than the other.

If you’re saving for retirement in 20 years, a higher-risk fund might work. If you’re three years from buying a home, the lower-risk option might be safer.

Final Thoughts

Measuring investment risk and return doesn’t require a finance degree. By understanding the tools used by professionals—like expected return, standard deviation, Sharpe Ratio, beta, and maximum drawdown—you can make clearer, more confident decisions.

These tools help you move from emotion-driven investing to evidence-based strategy. Whether you're building a pension, saving for a home, or investing for your children, having a handle on both potential rewards and potential risks puts you in control.

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