What is risk?
When investors talk about “risk”, they mean risk of losing money - some part or even the entirety of your original investment
The opportunity to gain money and the risk of losing money are two sides of the same coin: investors take more risk in order to reap higher profits
Among investors, risk is usually measured with measures like Volatility and VaR, which we’ll discuss in this article
What is risk?
When investors talk about “risk”, they mean the risk of losing money. For example, your shares in TSLA might go down 5% when you expected them to rally 30%. Or your SPY options might expire worthless, losing you all their value.
Risk & Returns
There is a relationship between risk and return in terms of investments: securities with a risk of larger losses also offer a higher chance of large gains. Put in a different way, investors require a higher return for holding higher risk assets.
When you read that an opportunity comes with a great risk/return tradeoff, investors are talking about a low level of loss and a comparatively large chance of gain. For example, a US treasury bond is considered a risk free asset because it is backed by the guarantee of the government. However, compared to a corporate bond, a government bond provides a lower rate of return - let’s say 1.36% vs 2.42% on a 10 year tenor.
This is because a corporation is more likely to go bankrupt than the government. On the other hand, since investing in corporate bonds holds default risk (risk of bankruptcy), investors expect a higher return for holding this asset.
What is volatility?
Volatility is a measure of the degree to which a security tends to move - we would call a currency that moves 1-2% in a week a low-volatility asset, and a stock that can move 30-40% in the same period a high-vol one.
Volatility is measured as the standard deviation of returns for a security - values ranging from 5% to 40% are all possible for your normal stocks. A portfolio with 5-6% volatility is considered a low-vol one.
Volatility is a key to option pricing (explained later). When you read about the VIX index, that’s an average measure of the volatility of S&P 500 implied in the stock market for the future
What is VaR?
VaR (value at risk) is a statistic used to measure the risk of loss for investments, giving the investor an idea of how much money an investment/portfolio/position could lose, based on a specific period in normal market conditions.
How can you mitigate risk?
Question time: if you put together a portfolio with 2 stocks, each with a volatility of 20%, what’s the average volatility of your portfolio?
Answer: the vol of the portfolio will be lower than 20%. This is because using two stocks brings diversification to the portfolio. Maybe when one is dropping, the other rallies and therefore the mix of the two is less risky than each separately
This is the core of how diversification works. Read more about it here.
What is diversification in portfolio management? (aka not putting all your eggs in one basket)
One of the ways to reduce your exposure to the different risks in the market is by diversifying your portfolio, so that you are not heavily affected by one industry or company. Not only can you diversify your equities by investing in different markets, but you can diversify your entire portfolio by investing in different asset classes. By doing this, you reduce your overall portfolio risk. For example, many investors hold commodities in their portfolios as these assets are hedged against inflation.
Romain (an equity investor) diversifies his equity portfolio and reduces his overall portfolio risk by investing in technology, tourism and agricultural stocks. Specifically in each industry, he invests in a few companies, rather than one, to reduce his exposure to a single company.
Euri (a macroeconomic investor) diversifies her portfolio and overall risk by investing in different countries. In the case that one country faces negative returns, her portfolio won’t be as heavily affected because she has investments in other countries which have positive returns.
Essentially, by not putting all your eggs in one basket, your wins are able to offset your losses, reducing your overall loss and portfolio risk.