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.
Quantitative Analysis
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.

Risk measures
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.
Look Out!
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).
Risk-Reduction Strategies for Stocks

Related Articles
  1. Investing

    5 Ways To Measure Mutual Fund Risk

    These statistical measurements highlight how to mitigate risk and increase rewards.
  2. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in Modern portfolio theory to quantify investment risk.
  3. Investing

    Systematic Risk

    Systematic risk, also known as volatility, non-diversifiable risk or market risk, is the risk everyone assumes when investing in a market. Think of it as the overall, aggregate risk that comes ...
  4. Investing

    How to Use a Benchmark to Evaluate a Portfolio

    What is an investment benchmark and how is it used to evaluate the risk and return in a portfolio.
  5. Investing

    PRHSX: Risk Statistics of Health Sciences Mutual Fund

    Examine the risk metric of the T. Rowe Price Health Sciences Fund. Analyze beta, capture ratios and standard deviation to assess volatility and systematic risk.
  6. Investing

    Understanding Volatility Measurements

    How do you choose a fund with an optimal risk-reward combination? We teach you about standard deviation, beta and more!
  7. Investing

    Quantitative Analysis Of Hedge Funds

    Hedge fund analysis requires more than just the metrics used to analyze mutual funds.
  8. Investing

    The Capital Asset Pricing Model: an Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  9. Financial Advisor

    Active Risk vs. Residual Risk: Differences and Examples

    Active risk and residual risk are common risk measurements in portfolio management. This article discusses them, their calculations and their main differences.
  10. Personal Finance

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
Frequently Asked Questions
  1. Why Do Most of My Mortgage Payments Start Out as Interest?

    Fear not: Over the life of the mortgage, the portions of interest to principal will change.
  2. What is the difference between secured and unsecured debts?

    The differences between secured and unsecured debt, and how banks buffer risks associated with each type of loan through ...
  3. How Many Times has Warren Buffett Been Married?

    Warren Buffett has been married twice in his life, but the circumstances surrounding the marriages were unconventional.
  4. What's the smallest number of shares of stock that I can buy?

    Many people would say the smallest number of shares an investor can purchase is one, but the real answer is not as straightforward. ...
Trading Center