If you ever watch CNBC or read about investing, you have undoubtedly heard about risk. This post focuses on what investment risk means and how you should look at risk when investing.
Investment risk is generally measured with beta. If a stock has a beta of one, the risk is equal to that over the overall market. Higher beta means higher risk. If you look up any stock on Google Finance, the beta is given at the top of the page. Toyota, for example, has a beta of .72. That means it is a low risk stock. Ford Motor Company has a beta of 2.57, which means it is more volatile and more risky.
But how does that impact you? If a stock has low risk, it will probably not go up or down very much. If a stock has a high risk it could take a big swing either way. There are two major reasons investors have to look at risk. First, investors have to know how risk averse they are. Second, that have to match that risk with return.
I am a little risk averse, but I am still young so I can afford a big swing in my portfolio. My stocks have a beta of .20, 1.43, .98, and .64. If weighted evenly, I have a portfolio risk of .81. That means my portfolio will be slightly less volatile than the overall stock market. With that level of risk, I would expect my gains, or losses, to be a little less than the overall market.
What does risk have to do with return? As I said in the previous paragraph, risk should be proportionate to return. If you invest in treasury bills, you have virtually no risk, and will get a little return. US government securities are considered the closest investment in the world to “risk free.” That is why US t-bill interest rates are considered the “risk free rate.”
Large corporate securities for established companies, called blue chips, are the second least risky investments, not including foreign treasury securities. Blue chip stocks, such as those included in the Dow Jones average, generally have low risk. One major measure of corporate risk is the bond rating system. Companies rated AAA, AA, A, or BBB bonds, are investment grade. BB and below are considered junk bonds. Like with other investments, high grades are less risky and give lower returns. Moody’s and Standard and Poor’s are the most well known bond rating agencies.
Rather than keep rambling on, I will open up the floor (comments) for questions.