Risk in an investment situation
Risk means that the return on investment would be less than the expected rate. Risk is a combination of possibilities because of which actual returns can be different or greatly different from expected returns. Thus risk can be high or low. In case we want to quantify how high or how low the risk in investment is going to be, we have to intimate the probability of various outcomes and their deviation from the expected outcome.
The risk involved in individual securities can be measured by standard deviation or variance.
Components of Risk
Total Risk = Systematic Risk + Unsystematic Risk
- Systematic Risk: It represents that portion of Total Risk which is attributable to factors that affect the market as a whole. Beta is a measure of Systematic Risk.
- Unsystematic Risk: It is the residual risk or balancing figure, i.e. Total Risk Less Systematic Risk.
The measure of Risk:
The Total risk is measured by the standard deviation. The Standard Deviation is a measure of how each possible outcome deviates from the Expected Value. The higher the value of dispersion (i.e. Standard Deviation), the higher is the risk associated with the Portfolio and vice-versa. Generally, the Standard Deviation of specified security or portfolio is considered to be the Total Risk associated with that security or portfolio. Standard Deviation is the average or means of deviations. Deviations are the movement in returns from the mean return. it measures the risk in absolute terms. Standard deviation is the square root of the variance. It is one of the measures of dispersion, which is a measure of by how much the values in the data set are likely to differ from the mean. It is denoted by sigma.
Standard Deviation of a Portfolio
The risk of a portfolio is not equal to the sum of its parts. This is because all securities are neither correlated with each other to the same extent or in the same manner nor are relationships expressible in linear or arithmetic terms. Choice of securities in a portfolio can either go about to increase the risk factor which is greater than the sum of the individual risk of securities. It can also be lower than the risk factor of the least risky security in the portfolio. Therefore, the Standard Deviation of a Portfolio is not the weighted average of the standard deviation of its individual securities, since it does not consider the correlation between different such securities and a common base, i.e. market return.
Co-Variance as a Measure of Risk
When two securities are combined, we need to consider their interactive risk or covariance. Co-variance explains the Deviation of the return of Portfolio from its Mean Value. Covariance is an absolute measure of co-movement between two variables, i.e. the extent to which they are generally above their means or below their means at the same time.