You now have a fair idea of the different types of risk. But is there some objective mechanism whereby we can say Investment X is riskier than Investment Y? Yes, we can, by computing the standard deviation of the returns of the investment over a defined time period. You don’t have to be a master in statistics to do this. Excel has the relevant function that will help you in the computation.

Is it possible to reduce risk? Yes, thanks to diversification. Here’s an example that explains how diversification reduces risk.

Suppose there is a city that has only one season; say summer or winter throughout the year. And you want to set up either a soft drink or coffee shop there. You have done some research and have found that if the year turns out to be summer, the soft drink shop will yield a 30 per cent return and the coffee pub will yield a 10 per cent return. And if the year turns out to be winter, the corresponding returns will be 10 per cent and 30 per cent for soft drink and coffee businesses, respectively.

You log on to Google and find that during the last 100 years, 50 years were summer and 50 were winter. So the probability of it being summer is 50 per cent and it being winter is 50 per cent.

So the expected return from soft drink is 20 per cent. [(0.5 X 30 per cent) + (0.5 X 10 per cent)]. Ditto for the coffee pub business. Now, even without getting into standard deviation you know that the businesses carry risk because there is a deviation from expected return. That is, the actual return could be either 30 per cent or 10 per cent, while the expected return is 20 per cent. Since the numbers are identical, the risks in the two businesses are identical.

On a friend’s advice, you decide to put money in both businesses. You invest Rs 60 in the coffee business and Rs 40 in the soft drink business. In summer, you would get 30 per cent from coffee and 10 per cent from soft drink.

Since you put 60 per cent of your money in the first and 40 per cent in the second, your summer return would be 22 per cent. [0.6 x 30+ 0.4 x 10] and winter return would be 18 per cent [0.4 x 30+ 0.6 x 10]. And since the probabilities of summer and winter are 50:50, the overall return would be 20 per cent. [0.5 x 22 + 0.5 X 18]. The deviation in returns in this case is smaller. While the expected return is 20 per cent, the actual return can be 18 per cent or 22 per cent. Clearly, diversification (putting money in both businesses) has reduced risk. In fact, at a certain mix, it can even eliminate risk.

Diversification reduced risk because while summer was good for soft drinks, it was bad for coffee. And while winter was good for coffee, it was bad for soft drinks.

In building an investment portfolio one, therefore, needs to hold on to different types of investments — equity, mutual funds, bond, real-estate, gold, art, etc. Risk reduction means that the risk of the portfolio is less than the weighted average risk of the investments that constitute the portfolio.

The historical long-term simple average annual rate of return of Equity, Gold and SBI three-year term deposit tracked since July 96 is 14.71 per cent, 8.38 per cent and 8.66 per cent, respectively. The corresponding risk computed using standard deviation is 7.59 per cent, 4.24 per cent and 2.34 per cent, respectively. When you create a portfolio of these three investments, a risk reduction takes place.

The table below captures the portfolio return, the portfolio risk and the weighted average risk for three categories of investors. Diversification has been useful for all three — the Aggressive investor, the Moderate investor and the Conservative investor.

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