Understanding Risk

A basic understanding of investment risk helps you to make wise asset allocation decisions.

Investment risk is the uncertainty of achieving a desired investment return. Risk is represented by the volatility of returns -- up 15% one year, down 15% the next year, etc. The standard measure of investment risk is called the standard deviation of returns.

Conservative investors have a lower risk tolerance than aggressive investors. As a result, they are generally less likely to accept the same level of risk to achieve their financial goals.

Let's look at monthly returns for two stocks, Gazelle Co. and Antelope Co. and calculate the two stocks' standard deviation. Gazelle's initial share price was $11.65. Antelope's initial share price was $15. Over the next 12 months, both stocks rose 20%. (We ignore dividends and taxes in this example.) The following table shows share prices at the end of each month:

Gazelle's share price was much more volatile as its monthly returns, as measured by the month-to-month change in share price, fluctuated more than Antelope's stock. Specifically, the standard deviation of Gazelle's stock was 6.45%, nearly a third of its one-year return of 20%.

In comparison, the standard deviation of Antelope's stock was much less. Its monthly returns fluctuated only 1.89%, or about 10% of its one-year return of 20%. The following table summarizes these statistics:

According to the risk-return trade-off principle, riskier investments have higher potential returns. In this particular case, however, Gazelle and Antelope offered the same returns while Antelope's stock had considerably less risk. A rational investor would prefer shares of Antelope to Gazelle over this one-year investment horizon since it produces the same rate of return at a fraction of the risk.

The following table shows the risk-return trade-off for the 50 years ended in 1996. Stocks offer the greatest rate of return over the long term of the three major asset classes. However, stocks also fell the most when returns were divided into five-year holding periods, declining 2.4% in one period. According to this table, bonds and cash never lost money for any of the periods.

Source: American Association of Individual Investors

Investment categories
There are several investment categories within each major asset class. Some investment categories offer a greater risk-return trade-off than others. For example, aggressive growth and growth stocks (and the mutual funds that invest in them) are riskier than income or value stocks. As a result, growth stocks generally have higher rates of return over longer periods.

A similar dichotomy exists for other asset classes. For example, within the bond asset class, categories such as corporate and junk bonds offer higher returns than Treasury or agency bonds in exchange for having more risk. What's important is finding those investments whose risk characteristics match your risk tolerance.

Other types of risk
In addition to investment risk, other types of risk exist. These include interest rate, liquidity, prepayment, default and currency risk.

Each of these risks should be understood prior to investing in securities whose characteristics exhibit them.

This information should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Updated: January 2004

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