Tuesday, April 22, 2008

Do you understand investment risk?

Talk of investment risk is abundant but what is investment risk really?


Stock investments are risky; Investing in corporate bonds is less risky but still carries some risk; Investing in government bonds is risk free; we each have our own risk preferences and should invest accordingly, and so on and so forth.

We all know and recite these market truths by heart. But do we understand investment risk for what it is?

Investment risk is often defined as “The volatility of returns. Generally, the higher the potential return over time, the higher the level of risk involved” (BT financial group).

Essentially, a riskier asset means the asset’s returns are more variable. The economic risks which are responsible for this volatility make good subjects for a series of different posts. Suffice to mention the following as sources for varying volatility of returns in different financial assets: Operational risk, financial risk, credit risk, market risks, geographical risks and more (endlessly more). Whatever the source, the result is volatility in the returns of a certain financial asset.

Alright, volatility in returns is still not clear enough: what does that translate into?

In finance volatility of returns of a certain financial asset is measured by the statistical tool of standard deviation. Before you run away to the sound of statistics let me explain how easy and intuitive this is. Standard deviation measures statistical dispersion or how widely the values, in this case, returns are spread. By calculating an average return for a certain stock and calculating the differences between this average and the actual returns over time we learn how volatile or how widely spread the results actually are. If results are close to the mean or average then the volatility is low. If they are widely spread then volatility is high. Here’s a short example of how standard deviation is calculated (notice we take the square of the spread from the average. That is done so negative and positive results will add up instead of cancel):


In this example 6 out of 12 returns fall within 1 unit of standard deviation from the average (+10%, - 10%). Another financial asset might display higher or lower volatility, or distance from the mean. The higher the volatility of a financial asset the higher the risk we attribute to it.

Government bonds will display lower volatility as the interest rates is government assured. These financial assets will be less influenced by the economic environment and will guarantee return if you hold on to the asset until payment. A stock will display higher volatility as it is more sensitive to the economy and all those risks we discussed earlier. Each influence will be translated to price shifts which increase the overall volatility of the stock.

Why is higher volatility associated with higher investment risk?

An obvious yet often overlooked question. The basic premise in this case is that as individuals we require a certain level of certainty for our future wealth which is translated to utility. Higher volatility implies a higher level of uncertainty and lower utility from a specific investment. Therefore higher volatility is translated into higher risks and in turn we demand a higher compensation for the risk taken in the form of higher returns.

How to we determine the level of return we require for the risk taken is a whole other story. If you find this subject matter interesting please let me know.

Image by dziner

1 comment:

Dividends4Life said...

Interesting read. Thanks for sharing it.

Best Wishes,
D4L