Deviation Risk Measure

The deviation risk measure is a financial risk metric employed to assess the volatility and risk associated with an investment portfolio. It is determined by measuring the variance between the expected return of a portfolio and its actual return over a specified period.

Deviation risk measure offers a quantitative means to gauge the potential risk inherent in an investment portfolio, enabling investors to make well-informed decisions regarding their risk tolerance. It is indispensable for investors, portfolio managers, risk managers, and regulators to manage and monitor risk exposure within financial markets.

• Deviation risk measures provide insights into the potential variability of an investment's returns compared to its average or expected return.
• The widely used deviation risk measure is standard deviation, a statistical measure that quantifies the extent to which an investment's returns have deviated from its average return over a specific period.
• Another important deviation risk measure is Value at Risk (VaR), which estimates the maximum potential loss an investment may experience within a specified confidence level.

Deviation risk measures are statistical measures used to quantify an investment portfolio's risk or volatility. They are based on the idea that a portfolio's actual returns may deviate from its expected returns over a given period. Deviation risk measures are important tools for investors, portfolio managers, and risk managers, as they provide a way to quantify the potential risk of an investment and manage and monitor risk exposure over time.

Standard deviation and Value at Risk (VaR) are the two commonly used deviation risk measures.

• Standard Deviation: Standard deviation is a statistical measure that quantifies the dispersion of returns around the average return of a portfolio. A high standard deviation indicates that the returns are more volatile, while a low standard deviation indicates that the returns are more stable.
• Value at Risk (VaR): Value at Risk (VaR) is a statistical measure that estimates a portfolio's maximum loss over a given period with a certain confidence level. Risk managers commonly use VaR to set risk limits and ensure that losses do not exceed a predefined threshold.

Let us look at these examples to understand the concept better:

Example 1: Stock Portfolio

Suppose you have a stock portfolio consisting of Stock A and Stock B. Over the past year, Stock A has had an average annual return of 8% with a standard deviation of 12%, while Stock B has had an average annual return of 12% with a standard deviation of 20%. Your portfolio is allocated 60% to Stock A and 40% to Stock B.

To calculate the deviation risk exposure of your portfolio, you would consider the weighted average of the standard deviations of the individual stocks. In this case, it would be:

(60% * 12%) + (40% * 20%) = 15.2%

The deviation risk exposure of your portfolio is 15.2%, indicating the expected volatility or risk associated with your investment.

Example 2: Art Portfolio

Imagine you have an art portfolio consisting of two types of artwork: contemporary paintings and vintage sculptures. Contemporary paintings are known to have higher price volatility, while vintage sculptures tend to be more stable.

The deviation risk exposure of your art portfolio can be assessed by considering the risk characteristics of the two types of artwork. The contemporary paintings represent higher volatility and risk, while the vintage sculptures represent lower volatility and risk.

In this case, your portfolio's allocation or proportion of contemporary paintings to vintage sculptures influences your deviation risk exposure. If you have a higher allocation to contemporary paintings, your deviation risk exposure will be greater due to the higher volatility associated with this type of artwork.

For example, if you allocate 70% of your art portfolio to contemporary paintings and 30% to vintage sculptures, your deviation risk exposure would be higher than 30% to contemporary paintings and 70% to vintage sculptures.

By assessing the risk characteristics and allocation of different types of artworks in the portfolio, one can evaluate the deviation risk exposure and make informed decisions about managing and monitoring risk in your art investments.

There are several benefits to using deviation risk measures, including:

• Provides a quantitative measure of risk: Deviation risk measures, such as standard deviation and VaR, offer a numerical assessment of the level of risk associated with an investment or portfolio. This enables investors to make well-informed decisions and adjust their investment strategies accordingly.
• Facilitates diversification: Deviation risk measures assist in identifying investments with low or negative correlations, which can be utilized to diversify a portfolio. Diversification helps reduce the portfolio's overall risk and potentially improves its risk-adjusted returns.
• Assists in pricing financial instruments: Deviation risk measures can be utilized to price financial instruments such as options and futures contracts. By quantifying the risk associated with these instruments, investors can determine their fair value more accurately.

However, there are some limitations, including:

• Assumption of the normal distribution: Deviation risk measures assume that the returns of a portfolio follow a normal distribution. Yet, this assumption may not hold true for all investments. Particularly in the presence of extreme events or non-normal distributions known as "fat tails."
• Limited consideration of extreme losses: VaR measures the potential loss at a specific confidence level. It does not account for the potential loss beyond this level. As a result, VaR may underestimate the potential downside risk, particularly during periods of high volatility.
• Insensitivity to return direction: Deviation risk measures do not differentiate between positive and negative returns. Consequently, two investments with the same standard deviation may be assigned the same level of risk.
• Ignoring inter-investment correlations: Deviation risk measures do not incorporate the correlations between different investments within a portfolio. As a result, the portfolio's overall risk may be either higher or lower than the sum of the risks of its individual investments.

This has been a guide to what is Deviation Risk Measure. Here, we explain the topic in detail with its examples, benefits, and limitations. You can learn more about it from the following articles –

• Risk Taker
• Political Risk
• Tail Risk