Understanding Financial Risk and Investment: An Introduction

Investor Preferences and Risk Tolerance

Task:

Investors differ widely in their preferences and tolerance for risk. Retirees are in need of known cash flows since they no longer work and hence generally will not accept much risk, younger people much further removed from retirement are generally willing and able to take on more risk, but only on the promise of more return. The positive relationship between risk and return is a fundamental relationship of investing.
The returns available on financial assets are well known and we have been dealing with them in the previous weeks. Bonds will generate cash in the form of coupon payments while stocks will return dividends and (hopefully) increased stock prices. We have investigated methods of estimating these returns, pricing the assets that generate the returns and discounting them to the present period. What we have not done is develop a technique to estimate and deal with financial risk.

Financial risk is defined as the variation of future returns. If the cash generated in the future is expected to fluctuate then the asset is risky per se. Treasury Bonds have the lowest possible risk because they are backed by the full faith and credit of the US government. These still carry a positive interest rate to reward investors for giving up the use of their money (i.e. not consuming) and for the potential of inflation which will dilute the purchasing power of their money once the bond is redeemed.

The most used and most typical statistical measure of risk is the standard deviation of the returns. As you will recall from your statistics and accounting classes the standard deviation is a statistical tool used to measure variation about the mean value – in this case the ‘mean value’ in question being returns on a financial asset. The calculation is straightforward and exactly the same as you learned in previous courses. A large standard deviation indicates greater return variability, or higher risk. Please recall that the standard deviation is in the same units as the data, i.e. in this case percent returns, and the calculation uses squaring and square root operations to avoid some technical problems that would arise in their absence. The standard deviation is the most widely accepted and used measure of risk in finance.

The volatility of stocks is much higher than the volatility of bonds and T-bills, and this is due entirely to the business and financial nature of the assets. While the stock market as averaged a 13.2% return since 1950, those returns come with high volatility, with a standard deviation of 17.0%. Bond and T-bill markets have much lower returns, but much less risk as well.

Estimating Financial Risk and Measuring Standard Deviation

Now that we can measure risk investors want to know how to get rid of it. This is done via a policy of ‘not putting all of your financial eggs in a single basket”. From the point of view of financial theory this is called portfolio theory and tells us simply to ‘diversify away’ the risk of individual assets by holding them in combination with other assets with different risk/return profiles.

Firm specific risk is specific to the company and common to other companies in the same industry while market risk affects all firms. The key idea of portfolio construction is to get rid of the firm specific risk by holding financial assets in combination with others whose returns have different standard deviations. In this way the risk that applies to individual firms can be muted to a large extent and the portfolio is then left with a risk profile much closer to the risk that affects all firms – the market risk. Because this market risk is general and pervasive it cannot be diversified away, but the risk inherent to individual firms can be eliminated.

Standard deviation measures total risk and we can reduce firm specific risk by combining stocks into a portfolio and for this reason; firm specific risk is also called diversifiable risk. On the other hand, macroeconomic events such as changes in interest rates, affect all companies

Diversification works in an incredibly simple fashion. The more assets in a portfolio the more cash flows come into it at different times and in different amounts. Because we measure risk by looking at the variation of the returns it stands to reason that the more ways we have to generate cash (the more stocks and bonds we hold) the lower the variation of those returns and hence the lower the risk.

Diversification comes when stocks are subject to different kinds of events such that their returns differ over time, i.e. the stock’s returns are not perfectly correlated.  Their price movements often counteract each other. Please note that if two stocks are perfectly positively correlated, diversification has no effect on risk.

The concept that diversification reduces risk was formalized in the 1950s by Harry Markowitz when he was a doctoral student at the University of Chicago.  He eventually won the Nobel Prize for his work. In addition to showing how risk reduction occurs when securities are combined, Markowitz’s modern portfolio theory also describes how to combine stocks to achieve the lowest total risk possible for a given expected return.  This is called an optimal portfolio.

Financial managers and investors must make investment decisions based on their expectations about future risk and returns. Managers also need to know what return their shareholders require so that they can meet those expectations. We saw in the last chapter that investors can easily diversify away firm-specific risk. We need to find a way to measure the market risk portion of stock ownership.