Being able to assess riskier stocks from less risky stocks is crucial when building a portfolio. It’s important for an investor to include stocks in a portfolio that meet their risk profile.
If someone is very open to risk, they may want to include a lot of risky stocks in their portfolio, while someone that is more risky adverse may prefer the opposite.
Only by measuring risk can an investor truly know whether a stock is a good fit for them or not.
Many of the measures of risk in finance are based on quantitative factors, most commonly past stock market performance. It’s important to note that investors should use a number of different approaches to assess the true riskiness of a stock.
In this lesson, we have included the most common approaches for measuring risk.
In order to fully explain the concept of Beta and how it’s calculated, it would probably take 20 lessons.
Beta is essentially a coefficient in a complex regression model that explains how volatile a stock is compared to the whole market.
Market risk has a beta that is equal to 1. If you invest in companies that have a beta of 1, you are basically investing in companies that have the same risk profile as the whole market.
Companies that have a beta that is higher than 1, are considered to be more risky than the market. The higher the beta, the more risky they are.
At the same time, companies that have a beta below 1 are considered less risky than the whole market. Therefore, it would theoretically be safer to invest in that company than in the whole stock market index.
Most of the time though, a lower beta results in a return that is less than the market.
It is possible for a company to have a negative beta, like -1, which means that the stock behaves in the opposite way to the market. So if the market goes up by 10%, the stock will go down by 10%.
A shortcoming of beta is that it represents the risk profile of a company at a particular moment in time. As time passes, the beta of a company can change significantly.
Standard deviation is somewhat similar to beta as a concept. It measures the volatility of a stock when compared to it’s average return.
The measure is calculated as a percentage and gives you an idea of the likelihood that a stock will meet it’s average return.
The smaller the percentage that a stock has with standard deviation, the more consistent it is.
For example, if a company has a standard deviation of 5%, it means that in any single year, the return can deviate from the average by 5%. If the average return is 10%, it would mean that in a good year the stock would return 12.5% and in a bad year it would return 7.5%.
Obviously stocks are risky assets and so a standard deviation of 5% is somewhat unlikely.
Nonetheless, on the extreme side, a stock may have an average return of 10%, with a standard deviation of 45%. This would mean that in a good year, the stock would achieve a return of 32.5%, and that in a bad year it would achieve a return of -12.5%.
You can see that the stock with the higher standard deviation is more volatile.
A shortcoming of standard deviation is that it depends on the timeframe in which you measure from. A company can have a drastically different standard deviation over a 5 year period, when compared with a 10 year period.
For the record, a standard in finance is to measure standard deviation across a 5 year timeframe.
The Sharpe ratio calculates the return that an investor will receive for an investment, compared to it’s risk.
It allows investors to quickly identify the risk profile of individual stocks.
It is calculated by subtracted the risk free rate from the expected return of a stock (or portfolio). The sum of that calculation is then divided by the standard deviation of that stock/portfolio, which gives you the Sharpe Ratio.
A Sharpe ratio of 1 is considered good, of 2 or above is considered very good, while 3 or above is considered outstanding.
To find information about the beta, standard deviation of Sharpe ratio of a stock, a simple Google search can usually give you the answers.
The main issue with this approach is in trusting that the information is reliable, which may not be the case.
Unless you understand how to calculate each measures on your own, it’s probably the best action to take.
Companies like the Financial Times offer reliable information that will quickly give you an idea of the riskiness of an investment.
As mentioned at the beginning of this lesson, most of these measures are based on the past performance of a stock and therefore may not give you an idea of the risk going future.
The assumption is that individuals stocks will perform similarly into the future – which is not necessarily true.
The ultimate way to assess levels of risk in an investment is to fully understand the underlying business and what factors drive the behaviour of the stock price.
This involves a lot of research, something that most new investors don’t have time to undertake. Sticking to what you know is the safest thing to do and avoiding getting involved in a company that you really don’t understand is advisable.
Diversification is key in order to lower your exposure to all of the risk factors that we explained in the previous lesson.