Understanding Risk
Risk and return
What is the relationship between risk and return?
It is a fundamental rule of investing that the riskier an investment is, the higher return an investor should expect for taking on that risk. Investment risk is the possibility that the security (stock or bond) will default or depreciate significantly in value.
But in order to assess just what return is required to compensate you for taking on risk, you need to work from a benchmark rate. This rate is known as the risk-free rate.
The risk-free rate usually corresponds to the rate available on a risk-free investment. In most cases it corresponds to the rate paid on long-term government bonds, which are considered relatively risk-free.
What is risk premium?
The risk premium is essentially the reward an investor expects for taking on risk. This premium depends on the amount a security can be expected to deviate from its purchase price.
A small-cap stock, for example, can be expected to be far more volatile than a government bond, therefore the investor will expect a return - let us say 15% - well in excess of the risk-free rate.
Example of risk premium
If a government bond provides a return of 5%, then we can easily calculate the risk-adjusted return, which in this case is 15% - 5% = 10%.
The risk-adjusted return equals:
You will not see the risk-adjusted return quoted anywhere because it is a theoretical concept, but try to apply it when making decisions. Estimate the risk-adjusted return in your head by comparing the investment return you are looking at with a risk-free return. Then you need to decide if that return is adequate compensation for taking on the risk.
Systematic risk and beta
Systematic risk is overall market risk as applied to a particular stock. It cannot be diversified against in a portfolio.
Systematic risk is measured by the beta coefficient. Beta is a measurement of a stock's volatility compared to an appropriate benchmark, which is given a beta of 1.
For instance, if the Standard & Poor's 500 is the benchmark index, then that index will have a beta of 1.
Depending on its volatility compared to the benchmark, a stock will have a beta of greater or less than 1. The higher the beta, the more volatile the stock; the lower the beta, the less volatile.
Example of Systematic risk and beta.
Suppose an investor is purchasing a stock with a beta of 1.5 relative to the S&P 500. This stock should have 1.5 times the volatility of the S&P 500. So if the S&P 500 were to increase by 10%, the stock should increase by 15%.
