“The biggest risk is not taking any risk. In a world that changing really quickly, the only strategy that is guaranteed to fail is not taking risk”, said Mark Zuckerberg, the king of social networking. This holds true in today’s world.
We always look for safety and believe that instruments which offer guaranteed returns are where our money needs to be. But we keep forgetting that there are monsters like inflation eating into our money every day. Without taking some amount of risk, fighting such monsters becomes impossible.
How much risk is too much for any portfolio? Unfortunately, it is not a simple question to answer. Do not worry, though. There are some mechanisms to understand the inherent risks in a portfolio and to make our job easier in choosing products that match our risk appetite.
Risks in holding securities can be of two types – systematic or unsystematic. Systematic refers to risk associated with economic, political or social changes. Unsystematic risk is one that is associated with a firm, sector or industry.
Beta
Beta is a mechanism used to measure systematic risk in a portfolio. Every portfolio has various crests and troughs. Beta measures the portfolio or stock movement with respect to the market, which could mean an index. If Beta is 1, it means the portfolio is moving in the same direction as the market does. If it is less than 1, it is less volatile and if it is more than 1, it implies greater volatility. Let us understand this with an example. If the Beta of a portfolio is 1.1, it means the portfolio is likely to go up by 110% if the market goes up by 100%. Also, it can go down by 1.1x the drop in the market. So when the market goes down by 50%, a portfolio with Beta of 1.1 will go down by 55%.
Standard Deviation
While Beta signifies the risk of a portfolio with respect to market, Standard Deviation (SD) talks about the absolute volatility. As the name suggests, SD refers to the amount of deviation in a stock or fund with respect to the expected returns. Obviously, lesser the SD, lower would be the volatility for the portfolio and vice versa.
Final Word
These risk measuring mechanisms cannot be the only factors in deciding a fund’s performance or in portfolio construction. They have to be combined with historical performance, fund manager track record, expenses charged, etc. To give an idea, look at the table, which shows the Beta and SD of various categories of mutual funds belonging to the ICICI stable.