For most of us, risk means the probability that playing in our daily "game", we get the outcome that we are not entirely satisfied. For example, when driving a car too fast we risk to earn a penalty, or, even worse, get into an accident. According to the dictionary Merriam-Webster's Collegiate Dictionary, the word "risk" means "to expose themselves to danger or accident." Thus, the risk is determined primarily by the terms having a negative connotation.
In finance, risk is understood in a different and somewhat broader. From the point of view of the financier risk means the probability that the return on investment will be made as expected. Thus, the risk includes not only the adverse (income lower than expected), but also favorable (income higher than expected) outcomes. In practice, the first type of risk can be called "risk reduction» (downside risk), and the second type - "upside risk» (upside risk), and the measurement of risk, we will consider both of these species.
The essence of the financial point of view, the risk is best expressed in Chinese characters denoting risk. The first character means "danger", while the second - a "favorable opportunity» (opportunity). Represented a combination of danger and of opportunity perfectly symbolizes the risk. Said very clearly illustrates the choice facing the investor - the higher the reward associated with a favorable opportunity, the greater the risk generated by the danger. In terms of financial risk we call "risk", and the opportunity - "expected return."
Metering and risk expected yield is difficult, because the content varies depending on the chosen viewpoint. For example, a risk analysis firm, we can measure it in terms of the management of the firm. On the other hand, we can state that the equity capital of the company belongs to the shareholders, and their perspective on risk is also worth taking into account. The shareholders of the company, many of whom hold its shares in their portfolios of securities of other companies are likely to perceive the risk of the firm quite differently than managers of firms that have invested significant capital into it, the financial and human resources.
Definition of risk
Investors who buy assets during his tenure they have come to expect a certain return. The actual income received in a given period of time, may be very different from those expected, and that's the difference between expected and actual income is the source of risk. The scatter about the expected actual income is measured by the variance (or standard deviation) of the distribution. The higher the deviation from the expected actual income, the higher the variance.
Expected return and variance used in practice, almost always evaluated on the basis of past, not future income. The assumption underlying the use of the variance of previous periods, is that the distribution of income earned in the past is a good indicator of the future distribution of income. With this assumption, inappropriate, such as when the asset characteristics have changed with time and historical evaluation can not be a good measure of risk.
Diversifiable and non-diversifiable risk
While there are many reasons why the actual income may differ from these estimates, but they can be grouped into two categories relating to specific companies and affecting the overall market.
The risk components. When an investor buys a share or a share in the equity of the firm, he exposes himself to a variety of risks. Some types of risk may relate to only one or a few firms, and this risk is classified as "risk at the firm level", ie, the so-called specific risk of the firm (firm-specific risk), which is the risk of investing in a particular company. Within this category, you can see a wide range of risks, from the risk that the firm misjudged the demand for its products by consumers. We call this kind of risk "project risk» (project risk). For example, consider an investment of Boeing's jet engine Super Jumbo. This investment is based on the assumption that airlines make demands on larger aircraft and are willing to pay higher price for them. If Boeing has miscalculated in its assessment of demand, it obviously will have an impact on profits and the value of the company, but hardly significant impact on the other firms operating in the same market. Moreover, the risk arises that the competitors can be stronger or weaker than anticipated. This kind of risk is called "competitive risk» (competitive risk). Suppose, Boeing and Airbus are fighting for an order from the Australian airline Qantas. The possibility that the competition can win Airbus, is a potential source of risk for the Boeing Company and, in all likelihood, for some of its suppliers, but, again, this risk will be affected only a few firms. Similarly, the company recently opened a Home Depot Store to sell their products for household purposes. The success of this project is important to Home Depot and its competitors, but it is unlikely for the rest of the market. In fact, measures of risk can be extended so that they involve risks affecting the entire sector, and thus were limited to this sector. We call this type of risk the sector risk (sector risk). For example, the reduction of the military budget of the United States will adversely affect all sectors of the defense industry companies, including Boeing, but will not have a significant effect in this case for other sectors. All three described species of risk - Design, competitive and sector - have one thing in common: they all involve only a small subset of firms.
There is another type of risk, with a much more extensive coverage, affecting many, if not all of the investment. For example, rising interest rates will negatively affect all investments, albeit in varying degrees. Similarly, the weakening of the economy all firms will feel the impact of the recession, although cyclical firms (such as automobile, steel and construction) are likely to be affected to a greater extent. We call this type of risk is market risk (market risk).
Finally, there are risks of occupying an intermediate position, depending on how many are affected assets. For example, when the dollar strengthened against other currencies, it will affect the profit and value of companies operating at an international level. If the majority of firms in the market has a significant volume of international transactions, the risk of increasing the dollar can be attributed to market risk. If international operations are busy few firms, then the risk is closer to the level of risk at the firm.
Why Diversification reduces or eliminates the risk at the firm level: an intuitive explanation. As an investor, you can make up your portfolio by investing all the money in one asset. If you act this way, you expose yourself to as market risk and specific risk of the firm. If you expand your portfolio to include the other assets or stocks, you diversify a portfolio, thereby reducing their dependence on the level of risk of investing in a private company. There are two reasons why diversification reduces or, within limits, eliminates specific risk of the firm. First, every investment in a diversified portfolio has a significantly lower weight compared to non-diversified portfolio. Any action that increases or decreases the value of investments to only one or a small group of investments, will have only a minor impact on the portfolio as a whole, while not allocate their investments investors are much more responsive to changes in the value of assets in the portfolio. The second reason is due to the fact that the impact of a single firm on the prices of individual assets in the portfolio can be either positive or negative for each asset in a given period of time. Thus, in a very large portfolio of firm-specific risk on average will be equal to zero, and will not affect the overall value of the portfolio.
Conversely, changes in the environment that affect the entire market as a whole, will act in the same direction for the majority of investments in the portfolio, although the impact on some of the assets may find it harder than others. For example, all other things being equal, higher interest rates will lead to a decrease in the value of most of the assets in the portfolio. Enhancing diversification does not eliminate this risk.
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