Mark Eric Ruiz, MBA, CFIMS, CUSP
In finance, risk refers to the possibility that the
actual results of an investment or decision may
turn out differently, often less favorably, than
what was originally anticipated. 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.
Systematic risk is unpredictable and impossible
to completely avoid. It's also known as
undiversifiable risk, volatility risk, or market risk.
It’s the result of macroeconomic events that
affect the market as a whole and cannot be
controlled, at least by an investor.
Systematic risk can't be mitigated through
diversification, only through hedging or by using
the correct asset allocation strategy. It underlies
other investment risks such as industry risk.
Systematic risk is that part of the total risk
that is caused by factors beyond the control
of a specific company or individual.
Systematic risk is caused by factors that are
external to the organization. All investments
or securities are subject to systematic risk
and, therefore, it is a non-diversifiable
risk. Systematic risk cannot be diversified
away by holding a large number of securities.
Market Risk
Interest Rate Risk
Purchasing Power Risk (or Inflation Risk)
Exchange Rate Risk
Unsystematic risk is a hazard that could damage
a single company or an industry sector while
having little or no impact on the broader world of
investments. Unsystematic risk is also known as
diversifiable risk because the wise investor can
reduce its impact by balancing investments
across multiple companies and sectors.
The opposite of unsystematic risk is systematic
risk. Airlines, for example, face unsystematic
risks of labor strikes, weather disruptions, and
regulatory changes. Most industries face
systematic risks of an economic downturn,
higher fuel prices, and geopolitical disruption.
Business Risk
Financial Risk
Operational Risk
Strategic Risk
Legal and Regulatory Risk
Beta is an indicator of the price volatility of a
stock or other asset in comparison with the
broader market. It suggests the level of risk
that an investor takes on in buying the stock.
The higher the beta number, the higher the
risk.
A security's beta is calculated by dividing the product
of the covariance of the security's returns and the
market's returns by the variance of the market's
returns over a specified period. The calculation helps
investors understand whether a stock moves in the
same direction as the rest of the market. It also
provides insights into how volatile—or how risky—a
stock is relative to the rest of the market.
For beta to provide useful insight, the market used as
a benchmark should be related to the stock. For
example, a bond ETF's beta with the S&P 500 as the
benchmark would not be helpful to an investor
because bonds and stocks are too dissimilar.
Covariance is a statistical tool that measures
the extent to which two random variables
(usually, the returns on two assets) change
together.
A positive covariance means asset returns
move together, while a negative covariance
means they move inversely. Covariance is
calculated by analyzing standard deviations
from the expected return or multiplying the
correlation between the two random variables
by the standard deviation of each variable.
Variance is a statistical measurement of how
large of a spread there is within a data set. It
measures how far each number in the set is
from the mean (average), and thus from every
other number in the set. Variance is often
depicted by this symbol: σ2. The square root
of the variance is the standard deviation (SD
or σ), which helps determine the consistency
of an investment’s returns over time.
Beta equal to 1: A stock with a beta of 1.0 means its price activity
correlates with the market. Adding a stock to a portfolio with a beta of
1.0 doesn’t add any risk to the portfolio, but it doesn’t increase the
likelihood that the portfolio will provide an excess return.
Beta less than 1: A beta value less than 1.0 means the security is less
volatile than the market. Including this stock in a portfolio makes it less
risky than the same portfolio without the stock. Utility stocks often have
low betas because they move more slowly than market averages.
Beta greater than 1: A beta greater than 1.0 indicates that the security's
price is theoretically more volatile than the market. If a stock's beta is
1.2, it is assumed to be 20% more volatile than the market. Technology
stocks tend to have higher betas than the market benchmark. Adding
the stock to a portfolio will increase the portfolio’s risk, but may also
increase its return.
Negative beta: A beta of -1.0 means that the stock is inversely
correlated to the market benchmark on a 1:1 basis. Put
options and inverse ETFs are designed to have negative betas. There are
also a few industry groups, like gold miners, where a negative beta is
common.
Systematic risk is that part of the total risk
that is caused by factors beyond the control
of a specific company, such as economic,
political, and social factors. It can be captured
by the sensitivity of a security’s return with
respect to the overall market return.
This sensitivity can be calculated by the β
(beta) coefficient. The β coefficient is
calculated by regressing a security’s return
on market return.
The capital asset pricing model (CAPM) describes
the relationship between systematic risk, or the
general perils of investing, and expected return for
assets, particularly stocks. It is a finance model
that establishes a linear relationship between the
required return on an investment and risk.
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 with its
expected return. In other words, by knowing the
individual parts of the CAPM, it is possible to gauge
whether the current price of a stock is consistent
with its likely return.
Unrealistic Assumptions
Several assumptions behind the CAPM formula have
been shown not to hold up in reality. Modern
financial theory rests on two assumptions:
Securities markets are very competitive and
efficient (that is, relevant information about the
companies is quickly and universally distributed
and absorbed).
These markets are dominated by rational, risk-
averse investors, who seek to maximize
satisfaction from returns on their investments.
Using the CAPM to build a portfolio is supposed to
help an investor manage their risk. If an investor
were able to use the CAPM to perfectly optimize a
portfolio’s return relative to risk, it would exist on
a curve called the efficient frontier, as shown in
the following graph.
An efficient frontier is a set of investment
portfolios that are expected to provide the highest
returns at a given level of risk. A portfolio is said
to be efficient if there is no other portfolio that
offers higher returns for a lower or equal amount
of risk.
Portfolio theory is defined as a framework for
constructing an investment portfolio that aims to
maximize expected return while minimizing risk,
taking into account the relationships and
correlations between different assets.
It involves a two-stage process, beginning with
beliefs about future performances of securities
and ending with the selection of an optimal
portfolio.
The modern portfolio theory (MPT) is a mathematical
framework that’s used to build a portfolio of assets
that maximizes the expected return for the collective
level of risk.
American economist Harry Markowitz pioneered this
theory in his paper "Portfolio Selection," published in
the Journal of Finance in 1952.
A key part of MPT is diversification. Most investments
are either high risk and high return or low risk and
low return. Markowitz argued that investors could
achieve their best results by choosing an optimal mix
of the two based on an assessment of their individual
tolerance to risk.
Acceptable risk
MPT assumes that investors are risk-averse, meaning
they prefer a less risky portfolio to a riskier one for a
given level of return. As a practical matter, risk
aversion implies that most people should invest in
multiple asset classes.
The expected return of the portfolio is calculated as
a weighted sum of the returns of the individual assets.
If a portfolio contained four equally weighted assets
with expected returns of 4%, 6%, 10%, and 14%, the
portfolio's expected return would be:
(4% × 25%) + (6% x 25%) + (10% × 25%) + (14%
× 25%) = 8.5%
The portfolio's risk is a function of the variances of
each asset and the correlations of each pair of
assets. To calculate the risk of a four-asset
portfolio, an investor needs each of the four
assets' variances and six correlation values
because there are six possible two-asset
combinations with four assets. Because of
the asset correlations, the total portfolio risk,
or standard deviation, is lower than what would
be calculated by a weighted sum.
ESG stands for environmental, social, and
governance. ESG investing refers to an investing
approach that prioritizes how companies score on
these metrics. Environmental criteria gauge how a
company safeguards the environment. Social
criteria examine how it manages relationships with
employees, suppliers, customers, and
communities. Governance measures a company’s
leadership, executive pay, audits, internal
controls, and shareholder rights.
ESG investing is sometimes referred to
as sustainable investing, responsible
investing, impact investing, or socially responsible
investing (SRI). To assess a company based on ESG
criteria, investors look at a broad range of behaviors
and policies. ESG investors seek to ensure the
companies they fund are responsible stewards of
the environment, good corporate citizens, and are
led by accountable managers.
Environmental: Investors evaluate corporate
climate policies, energy use, waste, pollution,
natural resource conservation, and animal
treatment. Considerations might also include
direct and indirect greenhouse gas emissions,
management of toxic waste, and compliance with
environmental regulations.
Social: This is how a company's relationships with
internal and external stakeholders are
evaluated.2 Does the company donate a
percentage of profits to the local community or
encourage employees to volunteer? Do workplace
conditions reflect a high regard for employees’
health and safety?
Governance: This ensures a company uses
accurate and transparent accounting methods,
pursues integrity and diversity in selecting its
leadership, and is accountable to
shareholders.3 ESG investors might require
assurances that companies avoid conflicts of
interest in their choice of board members and
senior executives, in addition to not using political
contributions to obtain preferential treatment or
engage in illegal conduct.
