The word "risk" is one of the most ubiq­ui­tous con­cepts in that it is present in every­thing that we do. Every ac­tion or even in­ac­tion car­ries a risk. Risk is some­thing that can ei­ther be ac­cept­ed, man­aged, trans­ferred or avoid­ed. In or­der to choose any of these paths you first need to un­der­stand what risk is and then, specif­i­cal­ly, iden­ti­fy the risk that you are deal­ing with. Note, risk is of­ten in the eye of the be­hold­er and may mean dif­fer­ent things to dif­fer­ent peo­ple in dif­fer­ent times and cir­cum­stances.

I will deal with var­i­ous as­pects risk over time but the fo­cus to­day is on in­vest­ment risk.

Un­der­stand­ing in­vest­ment risk is es­sen­tial to mak­ing good in­vest­ment de­ci­sions. More im­por­tant­ly, there are many peo­ple who in­vest but have not quite grasped the con­cept of risk and how it im­pacts on in­vest­ments. Fur­ther, the in­vest­ment land­scape and your life cir­cum­stances are both ever evolv­ing so ap­pre­ci­ate that risk is not sta­t­ic but is al­so con­stant­ly chang­ing.

Recog­nise that risk is de­fined dif­fer­ent­ly by an in­vestor and by a port­fo­lio man­ag­er and many times these dif­fer­ences in de­f­i­n­i­tion leads to mis­un­der­stand­ing be­tween both par­ties. A good start­ing point in terms of in­vestor ed­u­ca­tion is to dis­cuss risk from the per­spec­tive of the port­fo­lio man­ag­er. This will hope­ful­ly give you an in­sight in­to what is oc­cur­ring when you sit in front of an in­vest­ment ad­vis­er to dis­cuss how to in­vest your mon­ey.

Mea­sur­ing risk

The first point to ap­pre­ci­ate is that risk is mea­sur­able and this is done by cal­cu­lat­ing the volatil­i­ty of re­turns or the price volatil­i­ty for a stock, bond or any oth­er as­set. So from the per­spec­tive of a port­fo­lio man­ag­er, risk is not about gains, loss­es, fear, not be­ing able to re­tire or go­ing on a va­ca­tion. Risk, in this con­text, is a sta­tis­ti­cal mea­sure that can be nu­mer­i­cal­ly de­fined. The most com­mon mea­sure of risk is the stan­dard de­vi­a­tion of re­turns. How­ev­er, in­stead of go­ing in­to the de­tails of how this is cal­cu­lat­ed, you might bet­ter ap­pre­ci­ate the con­cept via an ex­am­ple.

Let's take two hy­po­thet­i­cal com­pa­nies, Steel­band Ltd and Ca­lyp­so Ltd. You paid $11.65 a share for Steel­band a year ago and, at the same time, $15 a share for Ca­lyp­so. The ta­ble shows their share prices at the end of each month.

Both stocks earned a rate of re­turn of 20 per cent for the year (round­ed to the near­est whole num­ber). On the face of it you will prob­a­bly think it did not mat­ter which com­pa­ny's share you held in your port­fo­lio.

A clos­er look at the ta­ble re­veals that Steel­band's share price was more volatile than Ca­lyp­so's.

Re­turn­ing to the math, the stan­dard de­vi­a­tion of Steel­bank's stock was $3.02 or 21 per cent of the av­er­age month-end share price of $14.58. Ca­lyp­so's share price had a month­ly stan­dard de­vi­a­tion of $2.77. This was on­ly 16 per cent of its av­er­age month end share price of $16.80

Risk and re­turn are re­lat­ed.

Greater risk should re­sult in a greater rate of re­turn and vice ver­sa. This is called the risk-re­turn trade-off. Both com­pa­nies gen­er­ate the same an­nu­al re­turn of 20 per cent but it was de­cid­ed­ly less risky to in­vest in Ca­lyp­so than in Steel­band. Ca­lyp­so was there­fore the more "val­ued" in­vest­ment be­cause it car­ried a low­er risk/re­turn pro­file than Steel­band.

The above sce­nario ap­plies to all as­sets, not just shares in the stock mar­ket. You can cat­e­gorise al­most any class of as­sets by the de­gree of risk. Stocks have his­tor­i­cal­ly been con­sid­ered riski­er than bonds and bonds riski­er than cash. Note that this as­sess­ment is sim­ply based on po­ten­tial volatil­i­ty of re­turns. If one were to look at risk from a dif­fer­ent con­text you are like­ly to get a dif­fer­ent analy­sis. That is­sue will be dealt with in sub­se­quent columns.

In ad­di­tion, with­in each as­set class (eg com­pa­nies list­ed on the stock mar­ket) some in­vest­ments are riski­er are oth­ers. It is there­fore im­per­a­tive you un­der­stand the risks as­so­ci­at­ed with the com­pa­nies that you are in­vest­ing in.

Among those in­vest­ments that are con­sid­ered to have a low­er de­gree of risk are bal­anced mu­tu­al funds, mon­ey mar­ket ac­counts and cash de­posits which are in­sured with the De­posit In­sur­ance Cor­po­ra­tion. In­vest­ing in gov­ern­ment-backed in­stru­ments–trea­sury bills and bonds–are con­sid­ered among the safest of all in­vest­ments. How­ev­er, they al­so of­fer the low­est com­par­a­tive re­turns.

Your tol­er­ance to risk

In or­der to put to­geth­er an in­vest­ment port­fo­lio, an ad­vis­er will want to as­sess your tol­er­ance to risk.

Recog­nise again that this is an as­sess­ment of how you see in­vest­ment risk as de­fined by your in­vest­ment ad­vis­er. It may not be the same as your con­cept of risk but it is a start­ing point for the con­ver­sa­tion on risk.

Your risk tol­er­ance is an ap­prox­i­mate mea­sure of your will­ing­ness to ac­cept in­vest­ment risk. If you are termed an ag­gres­sive in­vestor, you're more like­ly to ac­cept the risk of los­ing some of your in­vest­ment in ex­change for the chance to earn a high­er rate of re­turn. I do not like the con­cept of ag­gres­sive, mod­er­ate or con­ser­v­a­tive pro­files for in­vestors since my re­search shows that it of­ten leads to sub­op­ti­mal in­vest­ment de­ci­sions that are not in the in­vestors best in­ter­est.

How­ev­er, this is the per­spec­tive from which the in­dus­try and even the reg­u­la­tors ap­proach the is­sue of risk so this is where the con­ver­sa­tion has to start.

Af­ter as­sess­ing your risk pro­file the next step is to de­ter­mine if your cur­rent fi­nan­cial cir­cum­stances sup­port your risk tol­er­ance. You may have the ap­petite for risk but may not have the re­sources to sat­is­fy this ap­petite. Once you have put this to­geth­er, se­lect the as­sets you would like to have as in­vest­ments in or­der to meet your ob­jec­tives.

For spe­cif­ic in­vest­ment ad­vice, you should con­sult a fi­nan­cial ad­vis­er.

Ian Nar­ine is a bro­ker/deal­er and in­vest­ment ad­vis­er reg­is­tered with the SEC.