Coefficient of Variation: A New Way to Define Investment Risk
When the topic of risk management comes up, executives immediately think about business risk, while investors consider risk-adjusted returns. But few ever contextualize risk management as a tool to efficiently allocate capital. The foundation of risk management – the way in which risk is measured – is a calculation surrounding the spectrum of possible results. After all, an investment’s risk potential is defined by the volatility of the results. We can measure risk in absolute terms (standard deviation) or relative terms (beta). But there’s another way, too. For the sake of this piece, we’re going to discuss risk by using a lesser known metric: the coefficient of variation.
The coefficient of variation measures the amount of risk per unit of return. The ratio is useful when comparing investments with varying degrees of standard deviation and returns. The ratio is calculated as follows:
So at MPF Research, we looked at annual revenue growth for the apartment sector from 4th quarter 2004 to 3rd quarter 2014, and used the coefficient of variation ratio to compare the historical volatility and average annual revenue change at both the national and metro level.
Here’s how you read the chart below: the higher the coefficient of variation, the more risk per unit of return an investor takes on. So, according to the coefficient of variation, on a standalone basis, Phoenix ranks as one of the riskiest metros for investors. Then, when you look at the less risky metros – specifically Washington, DC, the Bay Area, Miami and San Diego – you see some common traits, such as high barriers to entry, strong growth in the 20- to 34-year-old age cohort and expensive single-family housing. However, the key takeaway is this: When using the coefficient of variation, it becomes clear that a metro on its own is typically more volatile the national norm. This makes sense since non-systematic risk can be reduced through diversification. The clear strategic implication over the past decade is that diversification works.