Monday, May 17, 2010

4 Things You Need to Know About Investment Risk


Many of us make investment decisions solely based on potential future returns; in playing the stock market game, for example, we are lured by the promise of generous investment rewards while ignoring the very real possibility of incurring losses. Investment risk is a factor or criteria that we often take for granted but should always consider in making any financial decision. Here are some important things that you need to know about investment risk.

1. Investment risk is the possibility of losing money in an investment. For some of us, it's not even the possibility of losing money, but rather the chance that we'll earn less than what we originally expected. While a finance person may point out that there are many other kinds of risk out there, the risk of a loss or a lower return is at the heart of everything and is the thing that all investors are most concerned about. Risk defined this way has two components: the possibility of a loss, measured with probability; and the extent of the possible loss, as measured by expected investment losses. Virtually all investment vehicles bear this kind of risk to a certain degree: from “risk-free” Treasury securities (which are not really risk free in the true sense of the phrase) to highly risky derivative instruments (what Warrant Buffet likes to refer to as “financial weapons of mass destruction”) like the dreaded CDOs or collateralized debt obligations, which were at the center of the financial crisis two years ago. Knowing this reality will lead to better informed (although not always correct) financial decisions.

2. Risk as the volatility of investment returns. A traditional way of measuring investment risk is by looking at the volatility of a stock’s (or any investment’s) historical returns. If you remember your college statistics, then you should know that the most widely used measure of data volatility is the standard deviation: the higher this quantity is, the more dispersed (or volatile) the underlying data or measurements are. The math part may not really be very important to most investors (although if you’re really serious about making informed financial decisions you should force yourself to (re)learn this and other statistical topics) since simply taking a look at stock price charts will clearly show how volatile stocks are relative to each other. In the image below, judging from how prices have gone up and down this past year, we see that the stock price of Geograce Resources Philippines Inc. (GEO) is significantly more volatile than that of Far Eastern University (FEU) and even than the PSEi (PCOMP) benchmark. The general rule is that the more volatile historical stock prices are (the sharper and more frequent price fluctuations are), the riskier the stock is and the higher the probability that you’ll lose money if you invest in the stock.

Image from

3. The tradeoff between risk and return. Frequent and steep spikes in stock prices are what some speculative investors actually look for; intuitively, the higher the probability of a loss (as indicated by these price spikes), the higher the chance of making a killing with the stock. In finance, it is a widely held and accepted belief that riskier investments also lead to higher potential gains, or simply “the higher the risk, the higher the return.” This financial truism may be clearly seen with evidence from the 100+ year history of financial markets in the US. In the image below, we see that in the past 100 or so years, risky common stock investments have significantly outperformed corporate bonds and risk-free Treasury bills in the same period. This is what “we” mean when we say that in the long run (which does not mean five years), riskier investments will result in greater returns than safer investments.

Image from Fundamentals of Financial Management, 4th Ed.

4. Diversify to minimize investment risk. Diversification is an investment strategy that is designed to reduce risk by spreading capital across many investments. Diversification works by investing in instruments that behave differently and so are affected by extraneous factors differently, so that when an event adversely affects one industry or firm, your investments in other unaffected (or less affected) industries or firms will cushion the the loss. An oft-quoted (and much maligned) analogy used to describe diversification goes like: “Do not put all your eggs in only one basket.” We all know what’s bound to happen to your eggs when that basket falls, don’t we?

So how do ordinary people like us achieve diversification? The science of determining an optimal portfolio which gives us the best return at a given level of risk (or the biggest bang for our buck, if you prefer) from a universe of available investments involves applying the fun and wonderful concepts of operations research, particularly linear programming.

Fortunately, diversified portfolio funds (things that we keep on talking about here and here) are very readily and inexpensively available to us, so we really don’t have to do any hard math to achieve diversification; knowing how it works and how it can be in our best interest to diversify our holdings is a good start in managing the risk of our investments.

Knowing what investment risk is and how it affects our investment choices is a critical part of making informed investment decisions. Understanding the tradeoff that exists between risk and return will help us choose investments that will lead to the biggest bang for our investment buck.
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