LEVEL: INTERMEDIATE
The level of risk an investor wants to take is met with a rate of return on an investment that varies in range according to the risk level. This means, the higher the risk, the wider the range of return the investor will realize. The lower the risk, the more narrow that estimated rate of return will be. Risk can vary from stock to stock, company to company, and economic environment to economic cycle. The level of risk investors can expose themselves to varies by age, income, aggressiveness, etc. All investments carry some amount of risk called systematic risk, which will be covered later. It is important to have an understanding of how measuring risks for different investments will help diversify a portfolio and lead to a positive rate of return on investments.
Beta is the most commonly used form of measuring risk for stocks. It is the measure of volatility of a stock compared to the overall market. Beta is used in the capital asset pricing model (CAPM) to calculate rates of return based on overall market performance. It is calculated by using regression analysis that examines the stock’s tendency to follow over market patterns. This means that beta measures how closely the stock will follow the market up or down. The index that is usually used as the benchmark is the Standard & Poor’s 500 (S&P 500). This is because the index is comprised of 500 different companies, this reflects a wide range of different industries and sectors that give a good outlook for how the entire market is preforming.
Beta is measured in numerical form. The market beta is always 1, this represents a perfect ratio of 1 to 1 to itself, obviously. Companies’ betas are then calculated and are either above 1, below 1, or 1 exactly. If the beta is above 1, this means that the security is more volatile than the overall market. This means that if the market is on an upward trend, the security, depending on how closely it is to 1, will be more volatile to either have a greater upward trend or possibly a declining trend, with a larger range of return.
If the beta is below 1, this means that the security is less volatile than the market. If the market was in an upward trend, the security would be less volatile and follow the upward trend, with a smaller range of return. Finally, if the beta is exactly 1, the security would have the same volatility as the market and would follow market movements at the same rate of return as the market.
The higher the beta, the more volatile the stock will be as a percentage of the distance from 1. For example, if a stock has a beta of 1.3, the stock would be on average 30% more volatile than the market. On the other hand, if a stock has a beta of 0.7, the stock would be on average 30% less volatile than the market.
Other Risk Measurements
There are other types of investment risk measurements that should also be examined when selecting stocks that satisfy your level of risk. First, Alpha is the measurement of the level of risk, not volatility, of the entire market. It is like beta, but instead of measuring volatility it measures risk. Secondly, the R-squared value is a measurement of the percentage of an investments movement that was attributed to the movements of the entire market. This is important because you might think you picked a good stock, but usually when the entire market goes up, so do the bad stocks. It is important to realize gains that were produced because of the individual stock’s performance and not just the entire market. Next, the Sharpe Ratio, measures whether an investment’s return is due to sound investing strategy or a result of excess risk. This is important because it allows an investor to examine if their returns, positive or negative, were because of proper research and smart investing techniques, or because of a high level of risk.
Finally, one of the more important measurements is the Standard Deviation of a stock. This measures how much a rate of return of a security is deviating from the expected rate of return of the same stock. This is important because it shows if the realized rate of return is in line with past averages or is a rare outlier. Investors can examine if their investments are just plain lucky or if their stocks are preforming the way they are supposed to perform.
There are many more ways for calculating the level of risk for a given security. Risk is an important idea to understand, so, depending on the desire and goals of the investor, the expected rate of return for a security is met or exceeded. It is important to pay attention to and realize the riskiness of an investment before you pull the trigger and throw money at it so you don’t take on a level of risk that isn’t needed if you were to invest in other securities with the same rate of return. When it comes to risk and return it is simple, you must try to find investments that have the highest rate of expected return with the lowest amount of risk, however it might be measured.