Understanding Risk

Any financial instrument is understood in terms of returns and risk. Investors try to maximize returns while minimizing risks. Well it is easier for us to understand returns but how do we define risks? Before measuring risk the relevant question which springs up in mind is

What is risk?

If we try to google the term, the first link (Wikipedia) shows what risk is. Click here for the definition. Now that definition is only partially true and does not picture the whole image. Try to google the term again with investopedia and you find this.

Taking the definition of investopedia as the starting point which says

“Risk is the chance that an investor’s actual return will be different than the expected”. And the unit for measuring it is standard deviation.

Now the next logical thing question which comes to mind is

Are there types of risks in financial market as we have in practical life?

The answer is in affirmative. Risk is of many types and is extremely important to understand its fine nuances as it would provide us the arsenal to manage it much more effectively. Delving deeper into the world of risks, broadly it could be classified into 2 categories.

Systematic Risk: This arises from the fact that every financial instrument derives some part of the risk from the underlying market. Every instrument being a part of the market gets affected by risks associated with the market.

Unsystematic Risk: The part of the risk which is unique to a particular financial instrument is known as unsystematic risk. Therefore Infosys stock will have different unsystematic risk as compared to Wipro’s stock.

Now each of these components could be further divided into many other parts which I will leave for the simplicity of the article.

Most of us would have heard about the famous saying “don’t put all your eggs in one basket” which when applied to financial market becomes Diversification Theory. It advocates for choosing a portfolio which distributes the risk or better minimizes it by picking up instruments from different asset classes which have different return-risk profiles.

Now with bit of knowledge about risk, it is no brainer that one could only diversify unsystematic risk with Diversification theory and his exposure to systematic risk is still pretty much open. Moving forward, one would imagine if there is a way to know the proportion of systematic risk out of the total risk.

Again the answer is in affirmative. The measure is called R2

R2 is defined as the ratio of systematic risk to total risk. Hence

R2 = Systematic risk/ Total Risk

Now one would ask what is the appropriate value for R2? Put differently how much proportion should systematic risk represent out of the total? And how much is it good for me?

Well this is a bit difficult question to answer as each investor has different investment objectives and different return-risk appetite. Also the nature of the instrument needs to be understood before comfortably saying anything about the value (for e.g. whether the stock is a mid cap or large cap). One the face of it, one would imagine lower value of R2 to be better but it would mean that the instrument behaves independently from the market and hence may cause more deviation from the expected return resulting in higher risks.

This was just a glimpse into the vast world of risk as total coverage is beyond the scope of this article. Hope the information was informative.