Risk Measurement

There are several types of risk, which bring fear to the minds of people. We are concerned about the risk of stock market investing. Research has shown that not all investors approach risk in the same way. Some investors take less risk to avoid losses rather than to obtain gains, while other investors are much more willing to risks to obtain gains rather than to avoid losses. Although the variability of the price of a security represents the data of past investment returns, the risk of investing is concerned with the uncertainty about future events. In spite of that, this price variability is frequently used as an estimate of risk.

Investing in the stock market carries inherent risks. Fluctuations in the market could mean that the value of the investment could rise as well as fall below the amount originally invested. The variation of each portfolio’s annual return is measured by the standard deviation of such returns, which is derived from its own data. Hence, the portfolio movement around its average of up and down throughout the year is known as volatility and is a measure of the risk of the invested portfolio. For example, a standard deviation of 12% means the value of the investment is likely to fluctuate by 12% or less above or below its average two-thirds of the time. A portfolio with a high standard deviation is associated with large swings in its value, and conversely, low standard deviation portfolios will have lower swings. Finally, the diversification of the portfolio holdings, coupled with rebalancing can increase the return when volatility rises, and it reduces the risk of the portfolio when volatility falls. It should be noted that future standard deviation may not be the same as in the past, and will depend on the price volatility.