The uncertainty of a future outcome is the simplest and most accurate way to describe risk. The anticipated return from an investment is known as the expected return. Whereas, the actual return over some past period is known as the realized return. The simple fact that dominates investing is that the realized return on an asset with any risk attached to it may be different from what was expected.
Volatility may be described as the range of price movement or price fluctuation from the expected level of return. The more a stock goes up and down in price, the more volatile that stock is. Because wide price swings create more uncertainty of an eventual outcome, increased volatility can be equated with increased risk. Being able to measure and determine the past volatility of a security is important in that it provides some insight into the riskiness of that security as an investment.
Investors and analysts need to be familiar with the study of probability distributions. standard deviation is used as an indicator of market volatility . Since the return is not known, it must be estimated. Standard deviation is high for more volatile securities.
Beta is a measure of the systematic risk that cannot be avoided through diversification. It is important to note that beta measures a security’s volatility, or fluctuations in price, relative to a benchmark, the market portfolio of all stocks. Securities with different slopes have different sensitivities to the returns of the market index. If the slope of this relationship for a particular security is a 45-degree angle, the beta is 1.0. This means that for every one percent change in the market’s return, on average this security’s returns change 1 percent. The market portfolio has a beta of 1.0. A security with a beta of 1.5, indicates that, on average, security returns are 1.5 times as volatile as market returns, both up and down. This would be considered an aggressive security because when the overall market return rises or falls 10 percent, this security, on average, would rise or fall 15 percent. Stocks having a beta of less than 1.0 would be considered more conservative investments than the overall market. Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is used by investors to judge a stock’s riskiness. Stocks can be ranked by their betas’. Because the variance of the market is a constant across all securities for a particular period, ranking stocks by beta is the same as ranking them by their absolute systematic risk. Stocks with high betas are said to be high-risk securities.
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