What is 'Risk'
Risk involves the chance an investment's actual return will differ from the expected return. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment.
BREAKING DOWN 'Risk'A high standard deviation indicates a high degree of risk. Many companies allocate large amounts of money and time in developing risk management strategies to help manage risks associated with their business and investment dealings. A key component of the risk management process is risk assessment, which involves the determination of the risks surrounding a business or investment.
A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk an investor is willing to take, the greater the potential return. Investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered one of the safest, or risk-free, investments and when compared to a corporate bond, provides a lower rate of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return.
On the other end of the investment spectrum, ultra-conservative investors avoid any type of risk to principal whatsoever. These types of investors seek safety and insured holdings such as bank certificates of deposits (CDs), whose one-year interest rate averages approximately 1.25% as of June 2016. Bank deposits are also insured by the Federal Deposit Insurance Corporation (FDIC), an agency created to maintain consumer confidence in the U.S. banking system.
U.S. Treasury's, backed by the full faith and credit of the U.S. government, also appeal to risk-averse investors. The three-month Treasury bill is considered a riskless security and is measured against securities that hold higher measures of volatility. As of July 1, 2016, the 91-day T-bill, purchased at a discount to par value, has a yield to maturity of 0.27%.
Morningstar Risk Ratings
Morningstar is one of the premier objective agencies that affixes risk ratings to mutual funds and exchange-traded funds (ETF). An investor can match a portfolio’s risk profile with his own appetite for risk. Highly volatile precious metal ETFs such as the Global X Gold Explorers ETF receive a high risk rating from Morningstar as the fund invests 48% of its holdings in international gold mining companies. The highly volatile fund holds a three-year standard deviation of 59.02 when compared to the Morgan Stanley Capital Index (MSCI) All Country World Index, whose measure is 11.82. Risk-hungry investors were rewarded with a 2016 year-to-date (YTD) return of 140.17% through June 30, 2016.