Understanding Risk and Return

What Is Risk?
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ
from an expected outcome or return. Risk includes the possibility of losing some or all of an
original investment.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance,
standard deviation is a common metric associated with risk. Standard deviation provides a measure
of the volatility of asset prices in comparison to their historical averages in a given time frame.

Overall, it is possible and prudent to manage investing risks  by understanding the basics of risk and how
it is measured. Learning the risks that can apply to different scenarios and some of the ways to manage
them holistically will help all types of investors and business managers to avoid unnecessary and costly
losses.

A fundamental idea in finance is the relationship between risk and return. The greater the amount
of risk an investor is willing to take, the greater the potential return.  Risks can come in various ways
and investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is
considered one of the safest investments and when compared to a corporate bond provides a lower rate
of return. A corporation is much more likely to go bankrupt than the U.S. government. Because the
default risk of investing in a corporate bond is higher, investors are offered a higher rate of return.

What Is a Return?
A return, also known as a financial return, in its simplest terms, is the money made or lost on an
investment over some period of time.

A return can be expressed nominally as the change in dollar value of an investment over time. A
return can also be expressed as a percentage derived from the ratio of profit to investment. Returns
can also be presented as net results (after fees, and taxes) or gross returns that do not account for
anything but the price change. 

What is Risk-Return Tradeoff?

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle,
individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or
risk with high potential returns. According to the risk-return tradeoff, invested money can render higher
profits only if the investor will accept a higher possibility of losses.

The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-
return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to
retirement and the potential to replace lost funds. Time also plays an essential role in determining a
portfolio with the appropriate levels of risk and reward.

Investors use the risk-return tradeoff as one of the essential components of each investment decision, as
well as to assess their portfolios as a whole.
Stand-alone Risk
What Is Standalone Risk?
Standalone risk is the risk associated with a single operating unit of a company, a company division, or asset, as
opposed to a larger, well-diversified portfolio. While a portfolio context takes all of the investments and assessments
into account when calculating risk, standalone risk is calculated assuming that the asset in question is the only
investment that the investor has to lose or gain. 

Standalone risk represents the risks created by a specific asset, division, or project. It risk measures the dangers
associated with a single facet of a company's operations, or the risks from holding a specific asset. For a
company, computing standalone risk can help determine a project's risk as if it were operating as an independent
entity.

Investors may examine the risk of a standalone asset to predict the expected return of an investment. Standalone
risks have to be carefully considered because as a limited asset, an investor either stands to see a high return if
its value increases or a devastating loss if things don't go according to plan.

Measuring Standalone Risk

Total Standard Deviation
A standard deviation is a statistic that measures the dispersion of a dataset relative to its mean. The standard
deviation is calculated as the square root of variance by determining each data point's deviation relative to the
mean. If the data points are further from the mean, there is a higher deviation within the data set; thus, the more
spread out the data, the higher the standard deviation.

Standard deviation is a basic mathematical concept that measures volatility in the market or the average
amount by which individual data points differ from the mean. Simply put, standard deviation helps
determine the spread of asset prices from their average price.

When prices swing up or down significantly, the standard deviation is high, meaning there is high volatility. On
the other hand, when there is a narrow spread between trading ranges, the standard deviation is low, meaning
volatility is low. What can we determine by this? Volatile prices mean standard deviation is high, and it is low
when prices are relatively calm and not subject to wild swings.

The Coefficient of Variation (CV)

The coefficient of variation (CV) is a statistical measure of the dispersion of data points in a data series
around the mean. The coefficient of variation represents the ratio of the standard deviation to the
mean, and it is a useful statistic for comparing the degree of variation from one data series to another,
even if the means are drastically different from one another.

In finance, the coefficient of variation allows investors to determine how much volatility, or risk, is assumed
in comparison to the amount of return expected from investments. Ideally, if the coefficient of variation
formula should result in a lower ratio of the standard deviation to mean return, then the better the
risk-return trade-off. 

The coefficient of variation is helpful when using the risk/reward ratio to select investments. For example,
an investor who is risk-averse may want to consider assets with a historically low degree of
volatility relative to the return, in relation to the overall market or its industry. Conversely, risk-seeking
investors may look to invest in assets with a historically high degree of volatility.

Portfolio Risk
What Is a Portfolio?
A portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and cash
equivalents.
People generally believe that stocks, bonds, and cash comprise the core of a portfolio. Though this is
often the case, it does not need to be the rule. A portfolio may contain a wide range of assets including
real estate, art, and private investments.

What Is Portfolio Risk?

Portfolio risk is a chance that the combination of assets or units, within the investments that you
own, fail to meet financial objectives. Each investment within a portfolio carries its own risk, with higher
potential return typically meaning higher risk.

In theory, portfolio risk can be eliminated by successful diversification: holding combinations of

investments that do not depend on the same circumstances to return a profit. In reality, though, it is more
probable that risks will be minimized and not eliminated entirely. 

Diversifiable risk and market risk make up the two major categories of investment portfolio risk.

What Is Diversifiable Risk?

Diversifiable risk is the risk that is unique to a specific company or industry. It's also known
as nonsystematic risk, specific risk, unsystematic risk, or residual risk. In the context of an investment
portfolio, diversifiable risk can be reduced through diversification.

Diversifiable risk can be described as the uncertainty inherent in a company or industry investment.

Examples of diversifiable risks may include strikes, outcomes of legal proceedings, or natural disasters.
This risk is  a diversifiable risk since it can be eliminated by sufficiently diversifying a portfolio. There isn't
a formula for calculating diversifiable risk; instead, it must be extrapolated by subtracting the
market risk from the total risk.
What Is Market Risk?
Market risk is the possibility that an individual or other entity will experience losses due to factors that
affect the overall performance of investments in the financial markets.

Market risk, also called 'systematic risk," cannot be eliminated through diversification, though it

can be hedged in other ways. Sources of market risk include recessions, political turmoil, changes
in interest rates, natural disasters and terrorist attacks. Systematic, or market risk, tends to influence
the entire market at the same time. Market risk exists because of price changes. 

Capital Asset Pricing Model (CAPM)

What Is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and
expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky
securities and generating expected returns for assets given the risk of those assets and cost of capital.

The formula for calculating the expected return of an asset given its risk is as follows:

Investors expect to be compensated for risk and the time value of money. The risk-free rate in the
CAPM formula accounts for the time value of money. The other components of the CAPM formula
account for the investor taking on additional risk.

The beta of a potential investment is a measure of how much risk the investment will add to a
portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater
than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the
time value of money are compared to its expected return.
For example, imagine an investor is contemplating a stock worth $100 per share today that pays a 3%
annual dividend. The stock has a beta compared to the market of 1.3, which means it is riskier than a
market portfolio. Also, assume that the risk-free rate is 3% and this investor expects the market to rise in
value by 8% per year.

The expected return of the stock based on the CAPM formula is 9.5%:

The expected return of the CAPM formula is used to discount the expected dividends and capital appreciation
of the stock over the expected holding period. If the discounted value of those future cash flows is equal to $100
then the CAPM formula indicates the stock is fairly valued relative to risk.

What Is Beta?
Beta is a measure of the volatility—or market risk—of a security or portfolio compared to the market as a
whole. Beta is used in the capital asset pricing model (CAPM), which describes the relationship between
systematic risk and expected return for assets (usually stocks). CAPM is widely used as a method for
pricing risky securities and for generating estimates of the expected returns of assets, considering both
the risk of those assets and the cost of capital.

Beta is a measure of a stock's volatility in relation to the overall market. By definition, the market,
such as the S&P 500 Index, has a beta of 1.0, and individual stocks are ranked according to how much
they deviate from the market.

A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than
the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide
higher return potential; low-beta stocks pose less risk but also lower returns.