How do I measure the risk of a stock?

Question

In finance, there are two primary measures of risk:

1) Total Risk (σ) which includes both market risk and firm specific risk

2) Systematic Risk (β) which is the risk relative to the market

In finance we assume that investors have a well diversified portfolio. This would imply that the unsystematic risk (i.e. the firm specific risk) is diversified away and all that matters is the systematic risk (i.e. the market risk).

Answer 1

Standard deviation unsystematic Risk (σ) measures the dispersion of data from its expected value. The standard deviation is used in making an investment decision to measure the amount of historical volatility associated with an investment relative to its annual rate of return. It indicates how much the current return is deviating from its expected historical normal returns. For example, a stock that has high standard deviation experiences higher volatility, and therefore, a higher level of risk is associated with the stock.

Below 3 stocks Total Risk (σ)

A= 12% Low Risk B= 15% Moderate Risk C= 20% High Risk

Beta  Systematic Risk (β) is another common measure of risk. Beta measures the amount of systematic risk an individual security or an industrial sector has relative to the whole stock market. The market has a beta of 1, and it can be used to gauge the risk of a security. If a security's beta is equal to 1, the security's price moves in time step with the market. A security with a beta greater than 1 indicates that it is more volatile than the market.

The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (or CAPM) describes individual stock returns as a function of the overall market’s returns.

Re= β x (Rm-Rf)+Rf

Re= Stock return

β = Beta coefficient

Rm= Market Return

Rf= Risk free rate

Example: 17.5%= 1.5 x (15%-10%) +10%