Measuring risk – Part 2

Determine your investment time horizon

The period of time for which you plan to stay invested in a particular vehicle is referred to as your investment planning time horizon. Generally speaking, the longer your time horizon, the more you can afford to invest more aggressively, in higher-risk investments. This is because the longer you can remain invested, the more time you’ll have to ride out fluctuations in the hope of getting a greater reward in the future. Of course, there is no assurance that any investment will not lose money.

What are the basic risks of investing?

Investment risk can be classified into two broad types of risks: (1) systematic or undiversifiable, and (2) unsystematic or diversifiable. Systematic risk is caused by economic, social, and political factors. These risks cannot be reduced by diversifying your portfolio. Unsystematic risks are associated with factors particular to the underlying company or industry, and can be reduced by diversification.

How is risk measured?

Risk is a rather fluid concept, yet experts have developed ways to measure it. To them, risk equals volatility, fluctuations in the price of a security or index of securities. The more fluctuation, the higher the volatility. Generally, the higher the volatility, the higher the risk--but also the potential for a higher rate of return.

Say that you have two investments. One always returned exactly 8 percent every single year, while the second investment’s return rate varied, gaining 15 percent one year, losing 3 percent the next year, then gaining 10 percent, then losing 13 percent, and so on. The first investment is characterized as having low volatility, low risk. The second investment is characterized as having higher volatility, higher risk.

Low-volatility investments are those whose performances are easier to predict than investments that are highly volatile. For example, although stock in well-established firms, such as General Electric, General Mills, or other blue chip companies can experience significant price fluctuations, the probability of this occurring is low. On the other hand, investors have come to expect fairly wide swings in the price of small-cap stock.

Volatile stocks tend to be those of small companies with few shareholders because they face challenges from the economy, rivals, and customers on a regular basis, or those of companies classified as “shooting stars.” A shooting star is a company that is experiencing growth at a rapid rate, but whose future is unpredictable. Stocks of small technology companies often are examples of this type.

The stock market has experienced extremely high volatility over the last few years. Record highs and unprecedented one-day declines have some investors feeling quite optimistic and others feeling very concerned.

What are the methods of measuring risk?

Measuring risk involves the use of mathematical tools and techniques, and assumes that volatility increases your risk of loss--and that risk worsens as your time horizon shrinks.

Standard deviation

The standard way to calculate the risk of a particular investment is to calculate the standard deviation of its past prices. This method measures an investment’s pure volatility. Standard deviation is a measure of the variation around an average or mean. In the case of an investment, the standard deviation measures how far away from the average the return rate for any one year is likely to be.

An investment whose rate of return never varies at all has a standard deviation of zero. An investment whose rate keeps varying, but always lies exactly 10 percent away from the average rate, has a standard deviation of 10 percent. Generally, the greater the standard deviation, the more variable the return and the riskier the investment.

One drawback to the standard deviation method is that some investors may think of deviation only as a negative, forgetting that prices fluctuate up as well as down. While it’s true that greater fluctuations may increase the risk that you may have to sell at an inopportune time, some investors prefer to try to take advantage of large price fluctuations in a stock with a high standard deviation.

Article courtesy of Forefield.Securities offered through NPB Financial Group, LLC. A Registered Investment Advisor/Broker-Dealer Member FINRA, MSRB, and SIPC