The Hindu Business Line : You can't wish away risk

Every security carries some degree of `risk'. The term risk means total risk in a security. Total risk can be broken into diversifiable and non-diversifiable risk elements.

The returns from a single security is the reward that the investor expects for the total risk assumed by him in such an investment opportunity. If one holds only one single security, one bears the total risk attributable to that security.

Total risk can be broken down into two elements. The first element is called specific risk (also known as diversifiable risk), which is relevant to the security itself (variance of an individual security).

This specific risk is the "contribution", per se, of one security to the risk of a portfolio and, therefore, is distinct for each individual investment. The second element is called non-diversifiable risk.

Also known as market risk, it is the risk that cash flows attributable to the project/portfolio (to which the individual security belongs) may be affected by factors that are beyond the control of the management of the entity.

An investor may have to choose amongst various investments, each offering similar returns but different levels of risk. He will select the one with the least risk.

"Total risk" in an individual security is the variability of its returns from the expected levels, Accordingly, the choice of the investor will be on that security or investment, in which variability of returns from expected levels would be less, relative to another security or investment.

This variability or total risk is measured by standard deviation.

The investor who normally views standard deviation or variance as a measure of risk would therefore be one:

who is evaluating the "total risk" in a security, and who is desirous of selecting "one single" investment, out of two or more alternative opportunities that give comparable returns;

but, is not evaluating the variability of returns, with reference to the extent of deviation in returns vis-à-vis market returns.

In sum, measurement using variance or standard deviation is relevant for evaluating the total risk attributable to a "single security".

This is preferred by those who are selecting one security but not a portfolio of securities.

(To be continued)

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