On my blog, I have alluded to stock market risk on a couple of occasions. A lot of people understand that stocks tend to out-perform other assets over time, but not many people fully understand the risk associated with investments such as stocks or commodities; or even what is meant by the term “risk”.
It turns out that there are several different types of risk associated with investments, but the one I will focus on today is price volatility. This is the risk that is most often alluded to and addressed through diversification and asset allocation.
The chart above shows the value of the S&P500 (in blue) compared to the value of Google (in red). Price volatility refers to the changes in price over time. In this case, note that the price of Google tends to swing much more wildly than the S&P. In fact, over the course of the last year, Google has swung from a gain of roughly 45% to a loss of close to 20% – a difference of roughly 65%. On the other hand, the S&P has moved from a gain of approximately 8% to a maximum loss of about 16%, or a difference of about 24%. So we can infer that the price volatility of the S&P (and therefore, the risk) has been lower than Google.
So here’s the risk: As price volatility increases, the probability that an investor will achieve a target return decreases.
It turns out that it is possible to quantify price volatility in order to describe the past risk associated with a stock or other investable asset. Often, this is done through a statistical measure called Beta or by calculating the standard deviation of a stock’s price over some period of time. RiskGrades also provides a number of tools that can be used to measure risk.
Continuing with the chart example above, I calculated the geometric standard deviation using Excel and weekly price data for both the S&P and Google. Through this calculation, the S&P had a geometric standard deviation measure of roughly 1.19. And over the same period, GOOG had a geometric standard deviation of 1.44. This shows, quantitatively, that GOOG has more risk associated with it, although it might also have an increased potential for price appreciation.
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