Gauging a Stock’s Risk

Posted on Friday, August 03, 2018

Stocks are primarily affected by two types of risk -- market risk and nonmarket risk.

Nonmarket risk, also called specific risk, is the risk that events specific to a company or its industry will adversely affect a stock's price. Market risk is the risk that a stock's price will be affected by overall stock market movements.

Nonmarket risk can be reduced through diversification. By owning several different stocks in different industries whose stock prices have shown little correlation to each other, you reduce the risk that nonmarket factors will adversely affect your total portfolio.

Yet, no matter how many stocks you own, you cannot totally eliminate market risk. However, you can measure how a stock has historically responded to market movements, selecting those with a volatility level you are comfortable with. Two tools commonly used to measure this risk are beta and standard deviation.

From the SEC

"All investments involve taking on risk. It's important that you go into any investment in stocks, bonds or mutual funds with a full understanding that you could lose some or all of your money in any one investment.

While over the long term the stock market has historically provided around 10 percent annual returns (closer to 6 percent or 7 percent 'real' returns when you subtract for the effects of inflation), the long term does sometimes take a rather long, long time to play out.

Those who invested all of their money in the stock market at its peak in 1929 (before the stock market crash) would wait over 20 years to see the stock market return to the same level.

However, those that kept adding money to the market throughout that time would have done very well for themselves, as the lower cost of stocks in the 1930s made for some hefty gains for those who bought and held over the course of the next twenty years or more."

-- The SEC publication 
Saving and Investing: 
A Roadmap to Your 
Financial Security

1. Beta

Beta, which can be found in a number of published services, is a statistical measure of how stock market movements have historically impacted a stock's price. By comparing the movements of the Standard & Poor's 500 (S&P 500) to the movements of a particular stock, a pattern develops that gauges the stock's exposure to stock market risk.

The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market and has a beta of one. A stock with a beta of one means that, on average, it moves parallel to the S&P 500 -- the stock should rise 10 percent when the S&P 500 rises 10 percent and should decline 10 percent when the S&P declines 10 percent. A beta greater than one means that the stock should rise or fall to a greater extent than movements in the S&P 500; a beta less than one means it should rise or fall to a lesser extent than the S&P 500. Since beta measures movements on average, you cannot expect an exact correlation with each market movement.

To measure your portfolio's overall risk, you can calculate a beta for your entire stock portfolio. First, find the betas for all your stocks. Then, multiply each beta by the percentage of your total portfolio that stock represents. Finally, add together all of the weighted betas to obtain the overall beta for your portfolio.

2. Standard Deviation

Standard deviation, which can also be found in a number of published services, measures a stock's price volatility, regardless of the cause. It basically gauges how much the stock's short-term returns have moved around its long-term average return. The most common way to calculate standard deviation is from an average monthly return over a three, five, or 10-year period, which is then annualized. Generally, the higher the standard deviation, the more volatile the stock is.

Consider this example. Assume you own a stock with an average return of 10 percent and a standard deviation of 15 percent. Sixty-eight percent of the time, you can expect your return to fall within a range of -five percent to 25 percent, while 95 percent of the time, you can expect your return to fall within a range of -20 percent to 40 percent. (This example is provided for illustrative purposes only and is not intended to project the performance of a specific investment.)

Standard deviation does not distinguish between positive and negative volatility. Thus, you should review a stock's range of returns over a period of years to determine whether that stock has a tendency to return more or less than its average return.

Taken together, beta and standard deviation can provide important information about a stock's volatility. If your stock is riskier than you realized, you might want to take steps to reduce that risk. When investing new funds in stocks, you might want to check the beta and standard deviation first.

Posted in Tax Topics For Individuals

Disclaimer: The information contained in Dulin, Ward & DeWald’s blog is provided for general educational purposes only and should not be construed as financial or legal advice on any subject matter. Before taking any action based on this information, we strongly encourage you to consult competent legal, accounting or other professional advice about your specific situation. Questions on blog posts may be submitted to your DWD representative.