Finance as a field is fundamentally risky. Every day, companies are bought and sold, markets move, and people gain or lose money. Short of a crystal ball, we can never tell for sure which companies will go belly up or which debtors will fail to repay their loans; the best we can do is guess. It’s like rolling a die; you can never predict what the next throw will be, but you know that with enough throws, each side will come up 1/6 of the time. In this way, we can guess the riskiness of an asset and act based on this information.
Measuring risk is a tricky discipline. Each asset type has its own measures of risk and different ways to quantify them. For example, the riskiness of stocks is often quantified by beta. Beta is a measure that describes the volatility of a company’s stock price in comparison to movements in the market as a whole. A company with a higher beta will have large price fluctuations, with both larger upsides and larger downsides. This is powerful information for an investor to act on.
To calculate beta, all you have to do is look at the historical returns of a stock compared to the stock market as a whole. When the market moves, does the stock price move by more or less? By averaging the relative size of these fluctuations, you can estimate the beta for the stock. In turn, beta can be used to price returns for a stock. Given their higher risk, stocks with a beta greater than 1 should produce returns above those of the market. Stocks with a beta less than 1 are less risky and should produce smaller returns than the market.
Another cool thing you can do with this kind of data is look at correlations of the returns of different stocks. That is, if the price of stock A goes up, what does the price of stock B do? If two stock prices generally move in different directions, that can be great insight for an investor. If you were to build a portfolio with just those two stocks, any price decrease in one stock would correspond with a price increase in the other stock, making the portfolio diversified. By diversifying your risk, you can achieve a portfolio that generally trends upwards.
Measuring risk for bonds is a different process entirely. Bonds are generally evaluated by credit rating agencies and given ratings like AAA or BBB. Like ratings for individual borrowers, they will evaluate the company’s trustworthiness based on its previous repayment of loans. They will also look at the company’s financial statements and perform some forensic work. How much interest is the company already paying? How comfortably is it able to afford this interest? What assets on its balance sheet can it liquidate to cover any shortages? Once the rating agency has an understanding of the company’s ability to handle debt, it will issue a rating. Using this rating, average investors can have a much clearer picture of the company’s debt riskiness.
Ultimately, risk measuring is all about averages. It won’t give you a picture of what will happen to the stock market tomorrow, or exactly where to invest your money. However, a smart investor can tailor the risk of his portfolio in the long run. By understanding the different measures of risk and where they come from, we can all make smarter investing decisions based on our own personal appetite for risk.