Investment and Managing Risk

Like everything in life, there is a risk, that usually refers to something not happening as we want, usually worse, or less than expected (downside risk) but there can also positive risk, in that we are surprised at an outcome that is better that expected (upside risk). The Oxford English Dictionary defines RISK as “(Exposure to) the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility”. See http://en.wikipedia.org/wiki/Risk.

For investors risk is the chance that an investment’s actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.

Marcus Padley, writing in The Age 27 nov 2010, http://www.theage.com.au/business/risky-business-some-basic-rules-to-cut-the-odds-20101126-18atc.html, explains more –  What is risk? It’s actually quite simple. In the financial world it is the difference between an investment whose returns fluctuate wildly and one that doesn’t.

Take two stocks. Both return an average of 5 per cent a year. But one stock’s annual return deviates from the average by 2 per cent a year (so it can return 3 per cent to 7 per cent in any given year) and the other one deviates by as much as 10 per cent a year (so it returns anywhere from minus 5 per cent to plus 15 per cent).

Clearly the first one is pretty predictable and the second one is moving around all over the place. It is much more risky. It is called standard deviation.

But you can’t tell from the average return alone how risky something is. That’s why, to judge the suitability of an investment, you need to calculate standard deviation as well. It is a measure of the volatility of returns or, in common parlance, risk. It is a measure of how reliable your returns are.

A further fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk.

Accordingly, government bonds are considered to be one of the safest (risk-free) investments and, when compared to a corporate bond or shares, provides a lower rate of return. The reason for this is that a company is much more likely to go bankrupt than the government. Because the risk of investing in company shares is higher, investors are offered a higher rate of return.

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