December 12, 2019
2 min read
Nicholas Flaherty - Investment Strategist - FWU Invest S.A.
Before embarking on an investment plan, you need to be aware of the risk you are taking. Why? If you are actually taking on more risk than you wanted, you could be severely disappointed if the investment goes wrong, while if you take on too little risk compared to your expectations, your return will very likely not match up to what you wanted.
But first of all, how do we define risk in finance? Basically, it means uncertainty of outcomes – the more we are unsure of an outcome of an investment, the greater the risk. So, for example, with a government bond, we are almost sure what kind of outcome we can expect from this investment in a couple of years’ time, meaning it has little risk.
When we look at stocks, however, which are much more affected by the economic cycle and are not ‘backed’ by a government, the outcome is far less sure, meaning they have more risk. Even within the stock market, there are large differences in risk. Take a big, traditional food producer for example: it has a large franchise, is globally diversified and sells staple products that people need no matter what. Although it is not as safe as a government bond, we can be reasonably sure what we can expect from this company, especially when we compare it to, for example, a new, start-up firm. Yes, the start-up may have grown a large following in a short period, but its market conditions are rapidly changing meaning the outcome is a lot less certain than with the large food producer, implying also that risk is considerably higher.
So, how exactly is this measured? This ‘uncertainty’ in an investment is measured using what is called the ‘standard deviation’ of returns, which is basically just a fancy way of saying ‘volatility’. It tells you how far the investment has been ‘deviating’ from its average return – the higher this number is, the riskier the investment is and vice versa. To put some concrete numbers on this, for the stock market as a whole the volatility is around 16%; while in the riskier areas of the stock market, such as Chinese technology companies, this number can go well over 40%. In the bond markets, volatility is generally below 10% and below 5% for many government bonds. In a nutshell, the more uncertain the likely outcome of the investment is the higher the number will be.
To put it all together for you, before you embark on an investment, do not just focus on return, but also keep a keen eye on risk. In order to assess risk, look at the ‘standard deviation’ of returns, or ‘volatility’, which will give you an idea of the risk you should be prepared for.