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Start for freeUnderstanding Risk in Individual Stocks and Portfolios
Welcome to the intricate world of investment risk and returns! As investors, one of the critical skills we need to master is the ability to calculate and understand the risk associated with individual stocks and the returns of a portfolio. Let’s dive into the details of how these calculations are made and why they are so important in the realm of finance.
Calculating Risk: Variance and Standard Deviation
The concept of risk is often quantified using variance and standard deviation. Variance represents the dispersion of stock returns around the mean value. Essentially, if you have a set of returns, you first calculate the average (mean), and then observe how far each return deviates from that average. A high variance indicates that returns fluctuate widely, which is synonymous with higher risk. Standard deviation, on the other hand, is simply the square root of variance, offering a more intuitive measure of risk.
Example of Variance and Standard Deviation Calculation
Imagine we have a stock with returns of +40%, +10%, and -20% in different economic conditions. If the mean return is 10%, we calculate the variance by subtracting the mean from each individual return, squaring the result, and then averaging these squared deviations, weighted by the probability of each return. With a variance of 450 in this example, the standard deviation would be the square root of 450, which is approximately 21. This number indicates the degree of variation from the mean return.
Gauging Portfolio Risk and Return
Portfolio Return Calculation
A portfolio is essentially a collection of different stocks or securities. The return on a portfolio is the weighted average rate of return of each constituent asset. To calculate it, you multiply the rate of return of each asset by its proportional weight in the portfolio, and then sum these figures.
Diversification: Mitigating Risk
The beauty of a portfolio approach lies in diversification. By spreading your investment across several stocks, you can mitigate the risk associated with any single stock. If one stock performs poorly, its impact is cushioned by the others that may be performing well.
Understanding Unique Risk and Market Risk
Investors must differentiate between unique risk, which is specific to an individual company, and market risk (systemic risk), which affects all stocks and is beyond diversification. Unique risks can be diversified away, while market risks cannot.
The Benefits of Diversification Visualized
To illustrate, consider a portfolio with equal investments in two companies, 'Newmont' and 'Ford'. If $100 invested solely in Newmont would decrease to less than $50, while the same amount in Ford would rise to $180 over a period, a balanced portfolio would result in less than $100, showing a loss but demonstrating risk mitigation.
The Asymptotic Nature of Risk Reduction
As you add more stocks to a portfolio, the average risk decreases but not infinitely. After a certain point, adding more stocks yields diminishing returns in risk reduction. This is depicted as the risk line becoming asymptotic – nearly flat – as the number of stocks in a portfolio increases beyond a certain threshold.
In conclusion, understanding how to measure and manage risk in individual stocks and portfolios is essential for any investor. Mastery of these concepts can lead to informed investment decisions and a more robust financial strategy.
For a deeper understanding and visual examples of these concepts, refer to the original video lecture on YouTube: Measure and Risk and Rates of Return.
