Making Money from Shares – Part 7: Understanding Risk

In order to manage your investments well, you need to have an understanding of risk and an appreciation of your risk tolerance. That is do you tolerate risk well or do you stay up at night worrying about the movement in the value of your stock market investments?

What is risk? Generally, it is defined as the probability that actual return will be lower than expected return. You can also think of risk in terms of price that is the probability of a drop in current market price compared to purchase price. Furthermore, you can consider the risk of a stock on a stand-alone basis or as the risk added to a portfolio of stocks. In simple terms, risk is the probability of a loss.

Many models have been developed to measure equity risk, these can be categorized as theory based models such as Capital Asset Pricing Model (CAPM) or alternative models that are based on intuitive or qualitative measures of risk such as models based on accounting statements (e.g. debt to equity ratio).

The CAPM is the most widely used model for measuring risk. It uses variance as the measure of risk. It assumes that a portion of the variance (risk) can be diversified away and that only the portion of the risk that cannot be diversified is rewarded. The non-diversified risk is measured using Beta. The standardized Beta is 1, that is the Beta of the market portfolio (for example the Nigerian Stock Exchange All Share Index).

Beta measures how a stock moves relative to the market portfolio. Therefore a stock with a Beta greater than 1, for example 1.25, is riskier than the market. It means that when the market moves up, this stock will move up 25% more than the market while if the market moves down, this stock will go down 25% more than the market. On the other hand, a stock with a Beta of less than 1, say 0.8, is less risky and less volatile than the market. If the market moves up 10%, this stock will move up but by 20% less than the market and if the market goes down 10%, this stock will go down by 20% less than the market.

The CAPM translates Beta into a relationship for expected return. The CAPM states that:

Expected Return = Risk Free Rate + Beta * Risk Premium

The Risk Free Rate is the rate of return of a riskless security like the Federal Government Treasury Bill rate while the risk premium is the premium you want for holding a risky security. So if the Risk free rate is 6% and the risk premium is 4% then the expected return for the market will be 10% (Beta of 1), while for a stock with Beta 1.2, the expected return will be 10.8% and for a stock with Beta 0.8 it will be 9.2%.

So how do you get the Beta of a stock listed on the Nigerian Sock Exchange? You can get the Beta calculated by some research companies such as BGL Securities or you can calculate the Beta of a stock yourself by running a regression of the actual returns of the security over some years (e.g. 3 years) over the actual returns of the market (the All Share Index) over the same period. You can find more details on regression from any basic book on statistics.

With a good understanding of individual risk of stocks and general market risk, it will be clear that you cannot eliminate all risk but you can only manage it. One way to manage risk is by putting your wealth in different asset classes. You can for example decide that 50% of your wealth will be in the stock market, 40% in real estate and 10% in money market. Of the 50% in the stock market, you can diversify your holding into 8 to 12 companies across 6 to 10 industries (sectors). You can also decide that no company will be more than for example 12% of your equity portfolio.

Another way of managing risk when buying a stock is to split the money into 3 or 4 tranches and then to buy in 3 or 4 batches thereby ensuring your average price is lower than the peak price. A popular way is to buy the same stock monthly consistently over a long period of time, your average price will thus be much less than the peak price and this is called cost averaging.

You can also manage risk by using the concept of margin of safety. That is if you calculate the value of the stock at N20, you can decide to only buy it after adjusting for a 20% margin of safety, which means at a maximum price of N16.

In summary, when it comes to risk you have to decide whether you prefer taking high risk or you prefer to be conservative. Thereafter you need to understand the risk associated with the stocks you own, your portfolio and then you need to manage the risk, because in investing risk is a fact of life that can only be managed but not completely eliminated.

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