How do you measure Risk ? Standard deviation and Beta

Measurement of Risk:

The investment risk is the probability of actually not earning the expected returns or maybe earning even lower returns. The investment is considered riskier if the chances of lower then expected returns are higher.

Standard deviation (si) measures total risk.

The larger the si, the lower is the probability that actual returns will be close to the expected returns.

Probabilities represent the likelihood of various outcomes and are typically expressed as decimal. The sum of all probabilities must be 1.0. because they must completely describe all possible outcome.

The probabilities are obtained on the basis of past occurrences with modification for any changes expected in the future. Investing for some future period involves uncertainty and therefore subjective estimates.

probability distribution can be either discrete or continuous. With a discrete probability distribution, a probability is assigned to each possible outcome. with continuous probability distribution an infinite number of possible outcome exists.

Expected Return
The expected value is the average of all possible return outcomes, where each outcome is weighted by its respective probability of occurrence, for investors this is expected return.

Government bond or fixed income security like bank FD the expected return is the rate of interest. there is no uncertainty about the expected returns. Stocks on the other hand give returns depending on the market conditions and one will have to estimate the possible returns and the probability of each of the possible returns.

Expected return = Sum (returns * probability)
example: returns 4%,8%,12%,16%,20% with probability of 0.1 ,0.2 ,0.4 ,0.2 ,0.1 respectively.
expected returns = (0.04*0.1 + 0.08*0.2 + 0.12*0.4 + 0.16*0.2 + 0.2*0.1)
= (0.004 + 0.016 + 0.048 + 0.032 + 0.02) = 0.12 = 12%

Standard Deviation

Variance or standard deviation is used to calculate total risk associated with the expected return. It is the measurement of the dispersion of random variable around its mean.
standard deviation is sqare root of variance
variance = sum of { probabilties * square(actual return - expected return)}
example taking the previous example
variance = { (-8*-8)0.1 + (-4*-4)0.2 + (0)0.4 + (4*4)0.2 + (8*8)0.1}
={ 6.4 + 3.2 + 0 + 3.2 + 6.4 }
= 19.2
standard deviation = square root of variance = square root(19.2) = 4.3817
NOTE: Variance,risk, volatility can be used synonymously, larger the standard deviation the more uncertain the outcome is.
standard deviation of large well diversified portfolio will be more stable then an individual stock.
hence for future estimation standard deviation of a diversified portfolio is better then an individual stock's standard deviation.

Beta

Beta is the measure of systematic risk of a security that cannot be avoided through diversification. Beta shows the price of an individual stock which performs with changes in the market. The more responsive the price of a stock to the changes in the market the higher is the beta.

Beta is relative measure of risk - the risk of an individual stock relative to the market portfolio of all stocks.

Beta 1 = Means every one percent change in markets return this security's returns changes by 1 percent

Beta 1.5= Means every 1 percent change in market returns this security's returns changes by 1.5 percent both up and down this would be considered an aggresive security meaning if market changes by 10% this security will change by 15% up or down.

Beta 0.5 or less then 1 = means the stock is more conservative investment then overall market.

Beta is mostly positive which means when the markets are rising the stock also rising and falling when the markets are falling. Negative beta means the stock is moving in opposite direction to the overall market.

To determine beta we use a graph we plot market returns on x-axis and the returns of actual stock on y-axis over certain period. upon plotting all the monthly returns over 1 year or certain period. we draw a line the comes closest to all the points this is called a regression line. Beta is the slope of this regression line. IF it is 45 degrees then the slope is 1 and beta is 1.

The more steeper the slope then more is the risk relative to the market. lesser the slope then more conservative the stock is compared to market.

Rs = estimated return on stock
a = estimated return when the market return is zero
Bs = measure of stocks sensitivity to market index
Rm = return on the market index
e= random errors
Rs = a + BsRm + e
If we consider return on security compared to risk free return then
Rs = Rf + Bs (Rm-Rf)
where Rf = risk free return - return that can be obtained by investing in risk free securities like treasury bills.

what are the Returns of Jeevan Astha single premium policy from LIC ?

According to the LIC brochure, one will get Rs 100 per Rs 1,000 maturity sum assured per year for a policy of 10 years and Rs 90 per Rs 1,000 maturity sum assured per year for a policy for five years. This where people make mistake of doing the simple calculation and assume that the rate of return is 9% for fiveyear plan and 10% for 10-year .

A 13-year-old (minimum entry age) who opts for a cover of Rs 1.5 lakh by paying a premium of Rs 24,668 would get around 7.32%, whereas a 60-year-old (maximum age) who pays Rs 29,145 as premium would get around 5.55%.

NOTE: People who want to park there money in debt product for 10 year expecting an assured return of between 5% to 9% along with some insurance can go for it.

Satyam fiasco ; I had kept on buying satyam stock regularly over the years !

Satyam fiasco may have shocked most of the investor community and it may have given another point to prove to the people who beleive in safe assets like FDs and LIC and PPF.

There is this person who says let us take a good bluechip company and keep investing and buying there stock regularly every month for a certain period and if you were the one who was investing in the Satyam stock might have lost more then 90% of your value in few trading sessions.

Does this prove that buying stock regularly or investing regularly is wrong strategy ?
No. The strategy is not wrong what the IMPORTANT LESSON to learn is that there was no diversification. yes you will find few companies doing wrong but there will be many more good companies out there. how do you know ? when even a index stock can behave like that.
Well the answer is you have to have DIVERSIFICATION. you need to shortlist 5 to 10 good scrips and invest for a long term. Another way would be to invest regularly in a index fund. Index does take care of this abberation like this time satyam is kicked out of NIFTY. so you dont have to worry about any company specific issues here also NIFTY is well diversified portfolio of 50 top stocks.
But then too much diversification also reduces your profit. well but that also reduces your risk also.
Well there are many small investors out there in the market who have full faith in Reliances and L nT's and Infosys and Tata's but I would strongly recommend dont have all your money in just one scrip.

Types of Investment risk

Systematic Risk
There are two types of risk one risk is pervasive in nature such as market risk or interest rate risk and the other is that are specific to the issuer risk, business or financial risk.

Total Risk = Systematic risk + Nonsystematic Risk
= Market risk + Issuer risk

All securities have some systematic risk whether be it bond or stocks, it encompases interest rate, market and inflation risk. This part of the risk cannot be avoided because know matter how diversified your portfolio, the overall risk cannot be avoided. If the stock market falls sharply most stocks will be affected and if it rises most stocks will rise.

Nonsystematic Risk
The variability in a securities total returns not related to market risk is called non market risk or nonsystematic risk. The risk is unique to a particular security and is associated with such factors such as business of financial, liquidity etc.
Systematic risk is associated to broad macro factors affecting all securities and nonsystematic risk is attributed to factors unique to a particular stock or security.

Market Risk
Market risk is non diversifiable risk. This risk is a systematic risk and it is exposed market conditions including recessions, wars, changes in economy, tax law changes, even consumer preferences.

Reinvestment Risk
In the context of bonds there is YTM (Yield to Maturity) . YTM is promised yield if the bond is held till the maturity. The bonds declare periodic interest the periodic interest should also be reinvested at the same rate as YTM but since the interest rate fluctuates this reinvestment may not get the same rate and hence it is called reinvestment risk.

The other way out is opting for a cumulative option were compounding of interest is done automatically and paid to the investor on maturity. This risk here is the opportunity loss of being able to invest the periodic receipt at higher rate then the current bond rate.

Interest Rate Risk
The variability in a security's return resulting from the changes in the level of interest rates is called interest rate risk. Interest rate generally affects securities inversely. Financial planner while considering fixed income securities should opt for short term debt product if he thinks the price might rise in near future and on the other side it would be good idea to commit for long term funds of interest rates have reached historic peaks and may fall in the future.

Purchasing Power Risk (Inflation risk)
There is a chance that purchasing power of invested money may decline.
example to explain say today you have Rs 100 and you can buy 5kg of Sugar (Rs 20 per kg) , This money is invested at the rate of 8% and it will become Rs 108 after one year. The inflation rate is say 10% and after one year price of sugar is Rs 22 per kg. Now after one year with Rs.108 you can buy only 4.9 kg of sugar. so your purchasing power has decreased. basicaly value of your money has eroded.

Liquidity Risk
Liquidity is being able to sell and realize cash value of an asset with least possible loss of time and money. An investment that can be bought or sold quickly without significant loss is called liquid. Treasury bill has no liquidity risk were as a small cap stock listed on regional stock exchange may have substantial liquidity risk.

Regulation Risk
Investment in PPF is tax free and even the interest earned is tax free. now if the govenrment changes the law then this can have huge effect on the final earning of this investment. Dividends from stocks and mutual funds are tax free in the hands of the investors hence they are investor friendly (This rules can be changed by goverment and are matters of regulation) This investment products are attractive because of tax concessions. this is the risk associated with investments in such products.

Business Risk
The risk of doing bussiness in a particular industry or environment is called business risk example commodities like oil and petrol are highly price sensitive and government policy of subsidising this products sustantially affect the profitability on companies engaged in manufacturing and marketing this products.

International Risk
It includes country risk as well as exchange rate risk.

Exchange rate risk
All global investors faces the prospect of uncertainity in the returns after they convert the foreign gains back to their own currency. it is also called currency risk.
If indian investor invest in abroad in dollars now afterwards he has to convert back to indian rupees and the mean while dollar - rupee exchange rate can have a big impact on the final returns.

Country Risk
It is more of political in nature. People always consider investing in more stable and growing economy. It is more risky to invest in a country were there is no political or economical stability.

Conclusion
Every investor has his own comfort level with risk. The is no "right or wrong" amount of risk, it is very personal in nature. however more younger you are more risk you can take and as you grow old you can take less risk.

Most investor should consider and proper mix of stocks and bonds. The younger you are ratio of stocks should be higher and the more older you are ratio of debt products should be higher.

Top performing equity diversified Mutual Fund in the month of December 2008

Top three equity diversified mutual fund for December 2008
1) JM Multi strategy fund - 23.9%
2) JM Contra Fund - 18.0%
3) DBS Chola Oppurtunities - 17.7%

This is just one month performance give for reference this cannot be used to make long term decision for investing.

Top performing ELSS Mutual Fund for the month of December 2008

Top three ELSS Mutual Funds for the month of December 2008
1) Can Robeco Equity Tax Saver Fund - 17.2%
2) DBS Chola Tax saver(G) - 14.7%
3) ICICI Pru Tax saver (G) - 14.0%

This rankings are just based on monthly performance this cannot be the basis for investing in this funds.

Investment planning: Understanding Investment Risk involved in financial planning

Risk in investment planning is not only that the chance that the person may lose his capital but more importantly a chance that the investor may not also get the desired return on investment product.
The investment products are
1. Fixed income instruments
2. Market oriented investments
There is always a risk/return trade-off. The greater risk taken the greater must be the potential return as reward for committing funds.

Risk Avoidance
If we know that eating outside food is not healthy so there is a risk that we may fall ill but if we dont eat outside completely we are avoiding the risk totally. If we dont invest in equities we are completely avoiding the risk of market downturn. but sometimes not investing in equities can be risk because of value of money reducing via inflation.

Risk Transfer
This is a better way to handle risk then risk avoidance. an easy example to understand risk transfer is concept of insurance. We have a chance of getting ill and getting hospitalised and exposed to the risk of high medical bills. we can transfer the risk of high medical bills to an health insurance company by taking a health cover for some fee called premium. There are many such examples in investing of risk transfer.

Influence of time on Risk
Investors need to think about time period in there investment plans. In case of an individual it may be planning for retirement, or down payment of home purchase or marriage on the cards. The longer the time horizon the more risk can be incorporated into financial planning.

Generally it is well established that equities as an asset class has outperformed all other asset classes and delivered superior returns over longer periods of time. with this statistics available, why wouldnt everybody invest 100 percent in stocks ? The fact is while over a longer term period stocks have outperformed but there have been may short term periods in which they have underperformed and infact had negative returns. Thus if you have long term then your risk is less but if you have short term horizon then your risk is high in holding stocks. Financial planner has to take into account the time horizon while structuring investment portfolios and the general rule is younger the person the longer is the time horizon and hence more exposure to equities.