Relative Risk is a financial metric that compares the risk level of an investment or portfolio relative to a benchmark or another asset, helping to assess risk-adjusted performance.
Relative Risk measures how much risk an investment or portfolio carries compared to a reference benchmark or another asset. It is used widely in finance and wealth management to understand whether an investment exposes the portfolio to more or less risk relative to a broader market index or a peer asset. This comparison often involves metrics such as volatility, beta, or downside risk. By identifying the relative risk, investors and advisors can make informed decisions about asset allocation and risk management strategies. In practice, relative risk can be calculated by dividing the standard deviation or beta of an investment by that of a benchmark. For example, if a portfolio has a beta of 1.2 relative to the S&P 500 (beta=1), its relative risk is higher, indicating it’s more sensitive to market movements. Conversely, a relative risk less than 1 suggests a more conservative or less volatile profile. This assessment helps wealth managers tailor investment strategies that align with their clients' risk tolerance and goals. Relative Risk also serves as a foundation for performance evaluation, helping to distinguish if higher returns are adequately compensated for by an elevated risk profile. It complements other risk metrics to provide a comprehensive overview of portfolio dynamics in relation to market standards.
Understanding relative risk is critical for aligning investment decisions with a client’s risk appetite and for optimizing portfolio construction. A portfolio that takes on unnecessarily high relative risk compared to its benchmark might generate higher returns but can also expose the family office to greater drawdowns, affecting long-term wealth preservation objectives. Precise measurement of relative risk allows wealth managers to adjust exposure, hedge unwanted risk, or diversify into assets that offer better risk-return tradeoffs. Furthermore, relative risk analysis plays a valuable role in performance attribution and reporting, enabling advisors to communicate clearly how an investment’s risk profile compares to expectations or industry standards. It also informs tax planning and governance by highlighting areas where risk concentrations could trigger unfavorable outcomes or necessitate rebalancing to maintain compliance with investment policies. Consequently, relative risk is an integral tool in maintaining disciplined, goal-aligned investment management.
Consider a family office portfolio with an annualized volatility of 12%, while the benchmark index has an annualized volatility of 10%. The relative risk is calculated as 12% / 10% = 1.2, indicating the portfolio is 20% more volatile than the benchmark. This insight helps the family office decide if the increased volatility aligns with their risk tolerance or if adjustments are needed.
Relative Risk vs Beta
While both relative risk and beta assess investment risk relative to a benchmark, beta specifically measures an asset’s sensitivity to market movements, indicating systematic risk. Relative risk, on the other hand, can incorporate various risk measures (like volatility, downside risk) and provides a broader comparison of risk levels. Beta is a component of relative risk analysis but focusing solely on beta may overlook other important risk dimensions.
How is relative risk different from absolute risk?
Absolute risk assesses the standalone risk level of an investment without comparison, typically measured by metrics like standard deviation. Relative risk compares the risk of an investment to a benchmark or another asset, showing how much more or less risky it is in relation to that reference point.
Can relative risk be less than 1?
Yes, if an investment has lower volatility or systematic risk than its benchmark, the relative risk will be less than 1, indicating a more conservative risk profile compared to the benchmark.
Why is relative risk important for portfolio diversification?
Relative risk helps identify how different assets or strategies contribute to the overall portfolio risk relative to the market. Understanding this aids in diversifying away from overly risky positions and balancing the portfolio to optimize returns while managing risk exposure.
