GAUGING THE RISKS OF INVESTMENTS
Learn even more about this topic with the Encyclopedia of Personal Finance™
To evaluate the potential risk—and return—of a
particular investment, many financial analysts look at a security's
long-term history. They calculate the security's volatility under
changing market conditions.
In an effort to evaluate the market as a whole, several
companies have developed various measures. The Dow Jones
Industrial Average, for example, tracks the performance of the
stocks of 30 large, successful companies. Other common measures of
the overall price movement of stock listed in the U.S. include the
Standard & Poor's 500 Index and the NASDAQ Composite
Analysts use measures of variance such as standard
deviation and beta to describe a security's volatility.
While standard deviation is an absolute measure of volatility, beta
is a relative measure of volatility.
Standard deviation is a statistical measure of how much
an investment's return varies from its average return over
The beta coefficient measures the price variance of a
stock compared to the market as a whole.
The Standard & Poor's 500 Index has a beta of 1. A stock with a
beta that is higher than 1 will be more volatile than the market as
The aim of all these calculations is to create an efficient
An efficient portfolio demonstrates the largest expected
return given a particular level of risk.
Conversely, an efficient portfolio also demonstrates the minimum
level of risk for the return expected. Combining investments whose
prices tend to vary in opposite directions lowers the volatility of
Analysts use the beta and other statistics to measure and
describe the risk and return trade-off in a given portfolio. Such
statistical analysis also can help an investor review and revise a
portfolio to match his or her personal priorities and risk comfort
Next up: Another issue related to gauging the risk vs.
return relationship is diversification.