Risk and Volatility

Lesson 1 Measuring Risk

Risk and Volatility

Aim: What causes an investment to not

achieve the results we expect?

Do Now: Identify the risks a person takes

between when he or she walks out the door in the morning for work and returns later that day.

Do Now answer: The person could get into a car accident. He or she could slip and fall while walking. The food eaten for lunch may be bad. None of these is expected, but there is a risk they could happen.

Risk and Volatility

Risk: The Volatility of ReturnsInvestments are uncertain. The actual cash flows that we receive from a stock or bond investment may be different than the expected cash flows.

The factor that causes the inequality between realized return and expected return is risk.

Risk: The Volatility of Returns

Realized Return: The return that is actually achieved from an investment.

If the cash flows received from a stock or bond

investment are lower than expected, the

realized return < expected return.

Risk: The Volatility of Returns

Expected Return: The return an investor anticipates generating from an investment.

If the cash flows received are higher than the

investor expected, the realized return > expected return.

How is Risk Measured in the Financial Markets?

Standard Deviation: How much the prices move around the mean, or average price. A statistical measurement that highlights historical volatility (fluctuation).

The normal distribution of a set of data is a “Bell Curve”. A bell curve depicts a data set in which the majority of the data falls close to the mean. The further the distance from the mean, the fewer the data points will lie under the curve (in the tails).

Risk MeasurementWhen returns are normally distributed, an individual return will fall within one standard deviation of the mean about 2/3 of the time (the grey area), which is 66.8% of the time. 94.5% of the time, returns are two standards deviations from the mean (the red area).

Risk MeasurementHigh standard deviation signifies a high degree of risk.If a stock is volatile (higher risk), it has a high standard deviation and the bell curve is relatively flatter. This is because the data is spread more evenly under the curve.

If a stock is not very volatile (low risk), it has a low standard deviation and then the bell curve is steeper. This is because an even higher majority of the data lies near the mean.

Example of VolatilityVolatility is the degree to which a stock’s price fluctuates. More fluctuation means the stock is highly volatile and less fluctuation means a stock is less volatile.

Example of VolatilityThere are several causes that result in realized return to be unequal to expected return. These are called risks.

They both start at $100 and end at $100. However, Stock B has much higher historical volatility than Stock A.

Each graph shows the historical prices of two different stocks over

the last 12 months.

Lesson Summary1. What is term we use for uncertainty?

2. If we were to plot a variety of possible outcomes for what an investment will be worth, what shape should we expect?

3. What do we call the variation from the mean that covers about 2/3rds of the outcomes.

4. When a stock’s price history is more volatile than normal, what does this mean?

5. What causes an investment to not achieve the results we expect?

Web Challenge #1Challenge: The classic “bell curve” represents the graphical layout of the potential outcomes for the value of an investment. It is used in other areas, such as displaying the range of student scores on an exam.

Including this example (if you wish), research three fields where the use of the bell curve is common. Provide an example of an actual bell curve showing real outcomes. Identify the industry and the meaning of the industry bell curve you identified.

Web Challenge #2Challenge: Find an investing risk tolerance quiz on the Internet and take it. Describe why you believe the result does or doesn’t accurately reflect you and your outlook. Also, identify any recommendations made about the appropriate types of investments for you.

Web Challenge #3Q: Should we be concerned for outcomes at the very ends of the bell curve? A: Yes. Even though they have a small

chance of occurring, if they do occur their effects can be catastrophic!

Challenge: Research the book “The Black Swan” by Nassim Taleb. Read a synopsis of the book. Identify and describe three of the main points of the book, including what a Black Swan is.