Aligning Portfolios With the Risk Index

Put risk into perspective by measuring volatility relative to a market benchmark.

Investing isn’t only about maximizing returns—it’s also about managing the risks required to achieve them. A metric that helps put risk into perspective is the risk index, which measures an investment’s or portfolio’s volatility relative to a market benchmark. By quantifying how an asset or portfolio moves in comparison to a standard benchmark like the S&P 500 index, the risk index provides insight into how volatile it is versus the market. Investors can use the risk index when constructing portfolios to better align their portfolio objectives and risk tolerance.

How Volatility Relates to Risk

A volatile stock, portfolio or other financial instrument is defined by large price swings over a short period of time. These movements can result in either gains (upside volatility) or losses (downside volatility).

Volatility is linked to risk because steep price declines can create shortfalls when an investor needs to make a withdrawal. Sharp, sudden drops can also shake investor confidence and prompt emotionally driven decisions.

Standard deviation offers a standardized and digestible measure of volatility compared to looking at price percentage changes. Taking the difference between two extremes in a series of returns would not show you how tightly other returns were clustered—for example, a series where the lowest return is –5% and the highest is +25% has a range of 30%. Consider the following two series of returns: –20%, 0%, 0%, 0%, +20%; and –20%, –19%, 0%, +19%, +20%. They each have the same range, but not the same volatility. The first series of returns will result in 4% higher wealth.