In the previous blog, we talked about the importance of risk. Risk is the fault line.
Finance experts have long applied a measure for risk. But to understand this measurement better, imagine a ship sailing through the ocean. Under calm weather, the ship will cruise at sea level. In stormy weather, the ship will bob up and down normal sea level. The greater the distance the ship bobs over and under normal sea level the more risky it would be to travel.
Ships are not the same size and shape. Due to their weight, the larger ones like oil tankers will bob less than the smaller one-man fishing boat. But all ships are nevertheless still at the mercy of the sea.
In a way, investment assets are like ships sailing the seas. Over a fairly long period of time, the returns on an asset are expected to fall within its intrinsic average. Therefore, the riskiness of an investment is how far actual returns fluctuate around that long-term average return. In finance this is called volatility and is measured in terms of standard deviation.
Forget the formula because spreadsheets can readily churn standard deviations. You can even get standard deviations from research firms and securities brokers. What is important to note is what standard deviation means.
The historical average annual return of the PSEi from 1988 to 2014 is 15.0% p.a. with a standard deviation of 41.6. This means that 68% of the time, the annual return of the PSEi fell within +56.6% p.a. and -26.6% p.a. (i.e. technically 68% of the time).
Now let’s compare these figures with those of the 364-day Treasury bill rates during the same years. For the given period, the one-year T-bills produced a historical interest of 10.9% p.a. and a standard deviation of +/-6.8. This means that the one-year T-bills was within +17.7% p.a. and +4.1%.
It can readily be seen from the figures that investing in stocks with its standard deviation of 41.6 is much riskier than investing in 364-day T-bills with its standard deviation of only 6.8. Moreover, returns of stocks could swing to the negative column while those of 364-day Treasury bills remained positive even on the downside.
Now we have the numbers to back up the statement that stocks are riskier than Treasury bills. Does an investment with a lower risk measurement mean that it is superior? Remember that investments are mere tools and that they were made for man (not the other way around). Inevitably, it will be a person’s return objectives as tempered by his risk preference that will say whether an investment is good for a particular individual.
There is never a single best investment. There is only an investment that is suited for an individual.
Next up, we will measure the risk in bonds.
(Originally written by Efren Ll. Cruz, RFP at http://www.savingstips.com.ph)
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