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But what exactly is meant by risk?
If someone invests into a stock, the risk is of a decline in the prices which would lead to losses for the investor. The returns from equity investments are volatile and this uncertainty is the risk.
It is very important for an investor to evaluate both the expected returns and the risks associated.
Some of the popular measures to evaluate risk in the context of stock markets are: –
– Standard deviation
– Value at risk
– Maximum drawdown.
First is Standard deviation
Standard deviation measures the dispersion of the periodic return from its expected value or mean. It measures the volatility of the periodic returns.
The formula for calculating the SD is =sqrt of ∑X-mean of Xn-1.
For example, if expected return from an instrument is 15% and its standard deviation is 5%. It means that though the expected return is 15% but it may frequently disperse around 10% to 20%.
But one drawback of measuring risk through standard deviation is that it calculates the dispersion to both the sides i.e. downside as well as upside.
Next is Beta
Beta is another common measure of risk. In the standard deviation we calculate the dispersion from its own historical price movement. While at the time of calculating Beta we need to calculate the risk relative to the market.
Any stock is exposed to two categories of risks – one is systematic risk and another is unsystematic risk. The risk associated with the internal factors of a company is called the unsystematic risk, while the risk associated with the overall activity of an economy or market is called systematic risk or the risk arising due to extraneous situations outside the control of the company.
So, if the beta of a particular stock is 1.3 then we can say that the stock is more volatile than the overall market. If the market moves up by 10%, the stock is expected to move higher by 13%.
Low Beta i.e a value lower than 1 suggests that the stock is less volatile in comparison to the overall market and is considered safer.
Next is Value at Risk
Value at Risk is a statistical measure used to measure and quantify the level of risk associated with a stock or a portfolio over a specific time frame. It is measured in three variables – the amount of the potential loss, the probability and the time frame.
For example, a Value at Risk of 10% at 95% confidence interval over 20 days indicates that the portfolio value will not depreciate more than 10% over the next 20 days with a 95% certainty.
Last one is Maximum drawdown
Maximum drawdown is a maximum amount of loss of a particular portfolio from its peak to its trough for a particular period of time. The formula for calculating the maximum drawdown is = Trough value – Peak value/Peak value.
One of the important parameters which determines your investment in the stock market is the percentage of risk you can take. Every amount invested in stock market will always have a good percentage of risk around it, and so, it will always be extremely important to measure your risk appetite, as well the risk involved in a particular investment class, before making any investment in stock market.
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