Measuring Risk
Investment risk can never be entirely eliminated, but many of the risks associated with stock investments may be reduced with proper industry diversification.
Diversification can mitigate the effect that a particular stock's decline in value will have on your overall portfolio. While diversification, through mutual funds for example, can protect against risks from a single investment or a single type of investment, it will not protect you against market and inflation risks.
Any investor seeking higher returns must be willing to assume additional risk. As a general rule, the higher the potential gain, the greater the risk.
To get a clearer picture of the degree of risk involved, carefully analyze the historical volatility of each stock you're considering.
A traditional way to measure risk when considering volatility is by comparing "betas." A beta represents the volatility of a given stock vs. the market as a whole. In general, stocks with high betas are deemed to be aggressive, while those with lower betas are usually considered defensive. For example:
A stock with a beta of one would be expected to move in tandem with the market averages.
A stock with a beta of 1.3 would be 30 percent more volatile than the market as a whole.
A stock with a beta of 0.5 would be expected to have half of the market's volatility (i.e., advancing 5 percent if the market advanced 10 percent or declining 5 percent if the market declined 10 percent).
Unsystematic Risk vs. Systematic Risk
Unsystematic risks are associated with a given company or industry. Examples include product delays, competitive issues, margin deterioration or weakening financial conditions within either a single company or an industry.
Systematic risks are associated with the stock market in general. While proper diversification can help eliminate much of the unsystematic risk from your portfolio, diversification with other stocks will not eliminate systematic risks. But diversification among different asset categories -- cash, bonds, real estate, etc. -- can reduce a portfolio's systematic risk below that found in stocks alone.
