We tend to think of "risk" in predominantly negative terms, as something to be avoided or a threat that we hope won't materialize.In the investment world, however, risk is inseparable from performance and, rather than being desirable or undesirable, is simply necessary. Understanding risk is one of the most important parts of a financial education. This article will examine ways that we measure and manage risk in making investment decisions.
RISK - GOOD, BAD AND NECESSARY
A common definition for investment risk is deviation from an expected outcome. We can express this in absolute terms or relative to something else like a market benchmark. That deviation can be positive or negative, and relates to the idea of "no pain, no gain" - to achieve higher returns in the long run you have to accept more short-term volatility
. How much volatility depends on your risk tolerance
- an expression of the capacity to assume volatility based on specific financial circumstances and the propensity to do so, taking into account your psychological comfort with uncertainty and the possibility of incurring large short-term losses.
ABSOLUTE MEASURES OF RISK
One of the most commonly used absolute risk metrics is standard deviation
, a statistical measure of dispersion around a central tendency. For example, during a 15-year period from August 1, 1992, to July 31, 2007, the average annualized total return of the S&P 500 Stock Index was 10.7%. This number tells you what happened for the whole period, but it doesn't say what happened along the way.
RISK AND PSYCHOLOGY
While that information may be helpful, it does not fully address an investor's risk concerns. The field of behavioral finance
has contributed an important element to the risk equation, demonstrating asymmetry between how people view gains and losses. In the language of prospect theory
, an area of behavioral finance introduced by Amos Tversky and Daniel Kahneman in 1979, investors exhibit loss aversion - they put more weight on the pain associated with a loss than the good feeling associated with a gain.
RISK: THE PASSIVE AND THE ACTIVE
In addition to wanting to know, for example, whether a mutual fund beat the S&P 500 we also want to know how comparatively risky it was. One measure for this is beta
, based on the statistical property of covariance and also called "market risk", "systematic risk
", or "non-diversifiable risk". A beta greater than 1 indicates more risk than the market and vice versa.
INFLUENCE OF OTHER FACTORS
If the level of market or systematic risk were the only influencing factor, then a portfolio's return would always be equal to the beta-adjusted market return. Of course, this is not the case - returns vary as a result of a number of factors unrelated to market risk. Investment managers who follow an active strategy take on other risks to achieve excess returns over the market's performance. Active strategies include stock, sector or country selection, fundamental analysis and charting.
Risk is inseparable from return. Every investment involves some degree of risk, which can be very close to zero in the case of a U.S. Treasury security or very high for something such as concentrated exposure to Sri Lankan equities or real estate in Argentina. Risk is quantifiable both in absolute and in relative terms. A solid understanding of risk in its different forms can help investors to better understand the opportunities, trade-offs and costs involved with different investment approaches.
Investing involves risk including the potential loss of principal. No strategy can assure success or protects against loss.
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