Types of Risks
Here are some risks associated with investing in the stock markets:
- Systematic risk - also known as market risk, this is the potential for the entire market to decline. Systematic risk cannot be diversified away.
- Unsystematic risk - the risk that any one stock may go down in value, independent of the stock market as a whole. This risk may be minimized through diversification. This also incorporates business risk and event risk, as described in the "Bond Risks" section.
- Other risks - opportunity risk and liquidity risk (as described in the "Bond Risks" section) may also apply to stocks in a portfolio.
One of the concepts used in risk and return calculations is standard deviation, which measures the dispersion of actual returns around the expected return of an investment. Since standard deviation is the square root of the variance, this is another crucial concept to know. The variance is calculated by weighting each possible dispersion by its relative probability (take the difference between the actual return and the expected return, then square the number).
The standard deviation of an investment's expected return is considered a basic measure of risk. If two potential investments had the same expected return, the one with the lower standard deviation would be considered to have less potential risk.
Standard deviation takes into account both systematic risk and unsystematic risk and is considered to be a measure of an investment's total risk.
There are three other risk measures used to predict volatility and return:
- Beta - measures stock-price volatility based solely on general market movements. Beta is a relative measure of systematic risk. Typically, the market as a whole is assigned a beta of 1.0. So, a stock or a portfolio with a beta higher than 1.0 is predicted to have a higher risk, and potentially, a higher return than the market. Conversely, if a stock (or fund) had a beta of 0.85, this would indicate that if the market increased by 10%, this stock (or fund) would likely return only 8.5%. However, if the market dropped 10%, this stock would likely drop only 8.5%.
- Alpha - measures stock-price volatility based on the specific characteristics of the particular security. As with beta, the higher the number, the higher the risk.
- Sharpe ratio - a more complex measure that uses the standard deviation of a stock or portfolio to measure volatility. It is a measure of risk-adjusted return. This calculation measures the incremental reward of assuming incremental risk. The larger the Sharpe ratio, the greater the potential return. The formula is: Sharpe Ratio = (total return minus the risk-free rate of return) divided by the standard deviation of the portfolio.
Of course, the reverse of "the larger the Sharpe ratio, the greater the return," is that the lower the ratio, the lower the potential return. If a security\'s Sharpe ratio were equal to "0", there would be no reward for taking on the higher risk, and the investor would be better off simply holding Treasuries (whose return is equal to the risk-free return component of the equation).
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