What is our best risk measure for stand-alone risk?
Standard deviation
Beta
Alpha
Variance
The correct answer and explanation is:
The correct answer is Standard deviation.
Standard deviation is the best risk measure for stand-alone risk. It quantifies the total risk of an investment by measuring how much the returns of the investment deviate from its average return. A higher standard deviation indicates greater variability in returns, which reflects higher risk. This is because standard deviation captures both the upside and downside potential of an investment, providing a complete picture of its overall volatility.
For stand-alone risk, which refers to the risk of a single asset or investment in isolation (without considering its relationship with other assets), standard deviation is a direct measure. It does not account for diversification or the correlation with other assets, making it appropriate for assessing the risk of an individual asset.
Beta, on the other hand, measures the risk of an asset in relation to the overall market or a benchmark index. It reflects the asset’s sensitivity to market movements and is more relevant for assessing market risk rather than stand-alone risk. Beta does not provide information about the asset’s individual volatility but instead focuses on its relationship with market movements.
Alpha is a measure of the risk-adjusted return of an asset or portfolio. It indicates how much an asset’s return exceeds or falls short of the expected return based on its beta. While alpha is important for assessing performance relative to expectations, it does not serve as a measure of risk, especially stand-alone risk.
Variance is another measure of risk, similar to standard deviation, but it represents the square of the standard deviation. While variance can be used to assess risk, standard deviation is generally preferred because it is expressed in the same units as the asset’s returns, making it easier to interpret.