Investing in stocks is a risky business. There are some risks you have some control over and other that you can only guard against. Thoughtful investment securities selections that meet your goals and risk profile keep individual stock and bond risks at an acceptable level.
However, other risks inherent to investing you have no control over. Most of these risks affect the market or the economy and require investors to adjust portfolios or ride out the storm.
There are two ways to measure risk. One is by using modern portfolio theory and the capital asset pricing model and the second is to look at the various risk factors which affect a business.
Capital Asset Pricing Model
We will not discuss in detail this theory of asset pricing as it requires you to have a working knowledge of first or second year university level statistics and finance. Since this is an introductory article, readers who are interested to learn more about the CAPM and Modern portfolio theory are encouraged to attend a course in finance or seek advice from a qualified advisor.
Basically, the CAPM makes some major assumptions about investors and their preferences. In order to use the CAPM to find the proper discount rate, one must know three things: a stock's beta, the nominal risk free rate, and the expected return on the market. Stock's with betas greater than one are more risky than the market and betas of less than one are less risky. For example, a stock with a beta of 1.5 is expected to gain 1.5% when the market rises 1%.
Modern portfolio theory is also where the main ideas about diversification come from. We will look at this concept in more detail later. For now, we can define a diversified portfolio as containing securities which have little or no correlation to other securities in a portfolio or the market. These securities are then placed in a portfolio in such a way as to minimize the volatility of the portfolio.
You may be scratching your head by now but this is essentially the basic concept of diversification and minimizing risk. There are a lot of disadvantages and advantages to using the CAPM and MPT. One assumption of the CAPM I will mention is that there are two types of risk. Market risk and firm specific risk. The CAPM assumes that investors only get a premium return for taking on market risk because the firm specific risk can be entirely eliminated through diversification. Thus, beta only measures market or nondiversifiable risk.
Second Way to Measure Risk
The second way to measure risk is to start by taking a nominal risk free rate. How do you do this? Well you take the yield that is currently offered on US Government bonds that match your investment horizon. For example, if you plan to invest for 5 years, you should use the yield on 5yr U.S. bonds. Now add to this the premium for risk and voila-you have your required return or discount rate. You may be asking, what makes up the risk premium? Well, remember from lesson one there are five things: financial, business, liquidity, foreign exchange, and political risk.
Financial risk involves a company's capital structure. What is their debt/equity? What is their current ratio? etc. We will look into how to assess financial risk in greater detail later in lessons on accounting and financial statements analysis.
This involves the economics of the firm you are looking at. Ask yourself, how will this company look ten years from now? Do they have barriers to entry? (ie patents, economies of scale etc. more on this in the economics lessons).
It has been shown through various studies that firms which are private or thinly traded are sold at a significant discount to their value compared with similar firms with active markets. Firm's which can be easily bought or sold with little transaction costs are called liquid or marketable. The lack of liquidity can occur if the stock you are researching is not widely followed. It can also happen if you plan to liquidate a large block of stock. Your transaction could bring down the price significantly.
Foreign Exchange/Political Risk:
This involves firms which derive significant portions of their sales overseas. For example, many exporters to Asia have been affected by weaker demand for their goods. Foreign Exchange/Political risk can also happen because the company you are looking into is heavily restricted by the government. Finally, different countries have different accounting rules so you should be aware of this when investing in foreign stocks.
When investing in foreign stocks, you also run the risk of the U.S. appreciating. To adjust for this, you should restate your foreign returns to U.S. returns.