Modules for Traders
Introducing the statistics of risk
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What is risk?
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Surely, you’re no stranger to risk. None of us are, isn’t it? Many everyday activities involve some degree of risk. Crossing the road, driving uphill, climbing on a stool to retrieve some items from an overhead cabinet, and even children playing in the local park - they’re all activities that carry different risks. There’s the risk of accidents, injury, and more. As a matter of fact, there are very few activities in life that carry no risk whatsoever.
Unfortunately, investing isn’t one of them. Investing in any asset comes with some degree of risk. What is this risk, though? Let’s look at an example before getting into the technical details.
Risk in investing: An example
Let’s tell you the story of two traders - Varun and Tarun. The story begins with Varun. At the end of FY 20, he received a bonus at work. And since he did not have any immediate need for that money, he decided to invest it in equity.
- So, on April 1, 2020, he purchased 100 shares of Tata Power at Rs. 105 each.
- Overall, he invested Rs. 10,500.
- A couple of months passed, and Varun kept his money invested, hoping to sell the stocks after the first quarter if there was an upswing.
- However, on June 3, 2020, there was a medical emergency in his family, and he decided to disinvest early to meet those financial needs.
Now, there was a problem here. While the stock price had been Rs. 105 when Varun had invested, it was now only Rs. 93. Initially, he had planned to sell his investments after the first quarter. But owing to the emergency, he was forced to disinvest, earning only Rs. 9,300 (Rs. 93 x 100 shares).
So, what was Varun’s loss? Well, he lost around Rs. 1,200 as a result of this transaction.
Now, let’s look at the trade executed by another investor - Tarun. On the same day Varun sold his shares at a loss, Tarun purchased those 100 shares of Tata Power at Rs. 93 each. Of course, this transaction occurred via an exchange, and neither Varun nor Tarun knew the other party.
- Tarun also decided to hold this investment till the company declared its Q1 results.
- So, when Tata Power released its results after the first quarter, the share price responded positively and rose to Rs. 107.
- Tarun sold his shares for a total of Rs. 10,700 (Rs. 107 x 100 shares).
So, what was Tarun’s profit? He earned around Rs. 1,400 (Rs. 10,700 - Rs. 9,300)
The moral of this story is that on every transaction, one party gains, while the other loses. Varun’s risk is that he lost Rs. 1,200 of the money he invested. Tarun, on the other hand, did not experience such a predicament. This principle forms the basis for the concept of risk in any investment. The risk may or may not play out in reality, but it always exists.
What is risk?
Let’s check out the risk definition. In finance and investing, risk is the probability that the actual returns experienced by the investor will differ from the expected returns. It signifies the chance of losing some portion of the investment, or in some cases, even all of it. From this definition, it is clear that risk and return are inherently connected.
And the general consensus is that the higher the risk associated with an investment, the greater the returns could be. In other words, if an investor is willing to take more risk with an investment, that investor also stands the chance of earning higher returns. By extension, the chances of suffering losses also goes up.
Let’s briefly explore the concept of expected returns before we delve further into risk. After all, the two are interlinked significantly. So, what are expected returns? Simply put, they are the returns that you expect from an investment. To explain this further, let’s take up two scenarios.
- You invest Rs. 200 in stock A, and you expect it to grow to around Rs. 240 after one year.
- So, you essentially expect Rs. 200 to yield a return of Rs. 40.
- The expected return in this case is 20%.
- Here, say you have the same R. 200. But instead of investing it all in the same stock, you split your capital.
- You invest Rs. 100 in stock A, and Rs. 100 in stock B.
- You expect stock A to yield a return of 20%, and stock B to yield a return of 10%.
- Basically, you now have a portfolio of two stocks - stock A and stock B.
In this case, what are the expected returns from your portfolio?
You can see that it is neither 20%, nor 10%. Then, how do you figure out the returns from the portfolio?
You can use this formula to calculate it.
Expected returns from a portfolio =
(Weight of asset 1 x Expected returns from that asset) + (Weight of asset 2 x Expected returns from that asset) + ……………. + (Weight of asset n x Expected returns from that asset) +
So, in this case, the expected returns would be:
= (50% x 20%) + (50% x 10%)
= 10% + 5%
Systematic risk vs. unsystematic risk
Now, coming back to risk again, there’s one very fundamental question. Is risk inherent to a particular asset? Or is it something that is linked to the market as a whole? To understand that, let’s take the example of a motorcycle.
Driving a motorcycle carries with it the risk of the rider getting into an accident. You’ll agree, isn’t it? This type of risk is broad-market - meaning that it applies to all motorcycles. Now, when we zoom in and look at the different types of motorcycles, we can classify them based on many parameters. One such parameter is the presence (or absence) of an Anti-lock Braking System (ABS). The motorcycles with ABS have a far less risk of skidding than those without ABS. So, this is a kind of risk that is specific to motorcycles without an ABS.
What does this tell us? Well, the summary is that there are two types of risk - generic and specific. In finance, this is what we refer to as systematic and unsystematic risk. The total risk of an investment is the sum of its systematic and unsystematic risk.
Let’s break down each of these concepts one after the other.
Systematic risk is the probability of a loss that is associated with the entire market or market segment. It is a risk that is linked with a market, as a whole. For example, investing in the stock market - as a broad category - carries its own risk. Similarly, the bond market also has its own set of risks. This is what’s referred to as systematic risk, and it is generally external to the asset that you’re investing in. So, it is also not within your control, and therefore, cannot be avoided as such.
Unsystematic risk is the probability of loss that is associated with a specific industry or security. For example, if stock A is considered to be more risky than stock B, this is a difference in the unsystematic risks of those stocks. Similarly, if investing in a cyclical industry like aviation is considered riskier than investing in a defensive industry like utilities, this is a difference in the unsystematic risks of those industries. They are specific to the asset or the industry in question.
The differences between systematic and unsystematic risk
Associated with a market or market segment
Associated with an industry or a specific asset
Extent of impact
Impacts the market as a whole
Impacts only select assets
Possibility of control
Cannot be controlled
Can be controlled
Means of hedging or managing
So, this gives you a basic introduction to risk. But how is it measured? That’s what we’ll be looking at in the next chapter. Head over there to understand how risk impacts your portfolio, and how you can quantify the risk for a stock and for a portfolio as a whole.
A quick recap
- In finance and investing, risk is the probability that the actual returns experienced by the investor will differ from the expected returns.
- It signifies the chance of losing some portion of the investment, or in some cases, even all of it.
- The higher the risk associated with an investment, the greater the returns could be.
- Expected returns are the returns that you expect from an investment.
- There are two types of risk - generic and specific. In finance, this is what we refer to as systematic and unsystematic risk.
- Systematic risk is the probability of a loss that is associated with the entire market or market segment.
- Unsystematic risk is the probability of loss that is associated with a specific industry or security.
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