One of the most typical problems that occur in these financial markets investors put cash into savings and investments with promises of expected returns. But without considering such a relevant issue as the previous one and depending on the most important cases. That it would be the risk. In this article, we will explain the issues that need to be known to determine the risk of an investment.
Types of risks, concepts to be clear
When you see the offers of brokers and private money managers, they offer profitability. Things like “the expected return are 5%”, on this basis we could think that this is based on statistics. Worth saying “events that may happen but that you do not have absolute certainty of it.” About the same, the tools which give me the statistical measures, these are the ones that will help us.
First, in order to arrive at the wished rate of return, a concept called “risk tolerance.” Used in statistics. And risk tolerance represents not more than the weighted average of all the events that may occur before a fact to be analyzed.
On the other hand, types of investments where the risk it comes defined as “how likely a deviation from the average return.” On the same basis, there you will find a concept called “standard deviation.” Which applied to finance, measures our investment risk.
Why the standard deviation investors use it to calculate risk?
Although standard deviation in investment comes determined in the same way as in statistics. It implies a different meaning when investing. This is a measure of the risk of an individual action and of asset portfolios. The present risk of any investment also determined in terms of the volatility of its returns. Volatility describes the fluctuation of the returns of an action over time and also with respect to the portfolio.
This indicator expressed as a percentage. Stocks of a large stock market capitalization have standard deviations of about 35 percent on average. While accumulated stocks of large capitalization have around 20 percent.
The standard deviation of high capitalization shares is like standard indicators such as the S & P and the NASDAQ.
To analyze the issue of risk, it is important to keep in mind two other concepts. One is the adverse event and the other is the consequence that hope does not materialize. All this again translates into how likely it is that things go wrong.
Standard deviation and the Thumb Rule
A practical rule of estimation used to know the average return, using the expected return and the standard deviation. For example, if the average return to investment is 10% and the standard deviation is 17%. Using the thumb rule, the probability of 10 +/- 17% is 68%, 10 +/- 34% is 95% and 10 +/- 51% is 98%.
The standard deviation in investment decisions
The standard deviation provides quantitative information on investment. This is used indirectly to lower the risk. The risk in investment is reduced by diversifying a portfolio, which implies buying capital with a negative correlation in terms of returns.
The negative correlation means that if one share of the portfolio is behaving badly, the other share goes up and vice versa. A good portfolio usually includes small and large capitalization stocks, bonds, commodities, and currencies.
The measure of risk could be part of the standard deviation in the long term:
Exchange Risk: a measured risk associated with higher volatility due to the exchange rate which directly or indirectly participates in the investment.
Credit Risk: Corresponds to the risk of uncollectibility of customers by companies.
Market Risk: Consists of the systematic and stock market risk associated with financial asset allocation.
Common Methods for Measuring Risk in Investing
There are three types of methods used to determine the level of risk of our business. The methods can be Qualitative Methods – Quantitative Methods – Semiquantitative Methods.
It is the method of risk analysis most used in decision making in entrepreneurial projects, entrepreneurs rely on their judgment, experience, and intuition for decision making.
Can be used when the level of risk is low and does not justify the time and resources needed to do a complete analysis. Or because the numerical data are inadequate for further analysis. Quantitative that serves as the basis for a later and more detailed risk analysis.
Qualitative methods include:
- Questionnaire and structured interviews
- Evaluation for multidisciplinary groups
- A trial of specialists and experts (Delphi Technique)
Word classifications are used as high, medium or low, or more descriptions detailed of the probability and the consequence. These classifications are shown in relation to an appropriate scale for measuring the level of risk. You must pay attention to the scale used in order to avoid misunderstandings or misinterpretations of the results of the calculation.
Quantitative methods are considered those allowing to assign occurrence values to different risks identified, which means, calculate the level of risk of a project. The quantitative methods include:
- Probability analysis
- Consequence analysis
- Computational simulation
The creation of these measures can be done in different ways, among which we highlight the Monte Carlo Method. Which is comes by:
- Broad vision to show multiple possible scenarios
- Implicitly to put it into practice
- Computerizable for the realization of simulations
Monte Carlo Method, a quantitative method for the development of risk analysis. The method, called in reference to the Principality of Monaco, for being “the capital of random game.”
This method seeks to represent reality through a maths risk model, assigning values random to the variables of such a model, different scenarios and results are obtained.
The Monte Carlo method, based on making a high number of iterations (adding values randomly), so the available sample of results, can be wide enough so it is considered a fake reality. These iterations can be done by making use of a PC.
With the results from the different iterations carried out. The study from which conclusions reach the project
How to calculate risk when investing in the stock market?
There are economic and political factors. Which provoked traders of the Stock Market to doubt whether to maintain their position or close it. in order to protect their money. For example, when the United Kingdom voted to get out from the European Union, or in the Americans election of Donald Trump to become
Called “aversion risk” and it represents the reason why some investors. First the most conservative, make “rush” decisions. To withdraw their money funded in equities and use it in accounts giving them low profits. Even lower than inflation or interest rate, warn analysts.
What does this mean?
You never know how long the stock market will continue to be expensive. Always a good idea to generate a long-term strategy in which there are constant savings and wider the portfolio.
The ideal strategy for a long-term traders portfolio. Which should have variable income and fixed income and place in two currencies, euros and dollars. Important to invest in indexes as S&P 500 or in a basket from 35 to 40 shares. Τhis way, the risk gets lower. If one company falls, others will have profits.
Conclusion about how to determine the risk of the investment
The best is to understand the concept of things. With data and information and applying statistics can lower the risk. Αnd on these same bases big theories comes from. Which help to reason the markets, annualized returns, etc.