Standard deviation can be used to measure risk

Posted On Monday, 01 March 2004 02:00 Published by eProp Commercial Property News
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The property investor needs to be able to measure the propensity of an investment to show returns which are different to - or deviate from - the projected return associated with the development.

Jonathan SmithA way to measure this propensity is to calculate the standard deviation: the potential distance from the expected return of an investment that can be anticipated. Before we consider the calculation, we should consider some introductory concepts:

THE RISK-FREE RATE OF RETURN: Since the investor traditionally links return and risk, the rate of return which the investor receives from an investment in which there is considered to be little or no risk is termed a risk-free investment return.

All investment opportunities carry some risk, of course. But some contain minimal risk, and can be used to determine a risk-free (return) rate to create a benchmark for other investments.

South Africa is fortunate to have a well-developed bond market. Certain bonds - those repayable by the government, quasi-government corporations and larger financial institutions - are considered risk-free. Thus, the return offered in the open market by a selected bond could be considered to be the minimum return that a property investor would require from a property investment. It is prudent to select a bond which is repayable commensurate in time with the intended length of a property investment. This risk-free or bond rate is used in one of two ways: nto determine the minimum pre-risk adjusted return required by an investor in a property development or portfolio; and nto discount an anticipated future cash-stream benefit from a property development to derive a present value of the cash stream.

STANDARD DEVIATION: The amount by which an investment is projected to be capable of deviating from expected return is termed standard deviation. There are two steps to calculating this: (1) the calculation of the expected (mean) return from an investment; and (2) the calculation of the propensity of an investment return to deviate from such expected return. The wider the distribution of possible return-levels, the higher the standard deviation and the higher the risk.

 

Last modified on Monday, 26 May 2014 10:56

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