Risk and Reward. Measuring volatility risk while investing in stock market

Picture this. There are two scrips recommended by your SEBI-registered investment advisor — Scrip A and Scrip B.

Over the past five years, the price of Scrip A has risen from ₹100 to ₹225 while that of Scrip B has increased from ₹100 to ₹250.

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Both companies are in the same sector and are well-established. Which one would you choose?

Your immediate response would be Scrip B, but, wait a minute, take a look at the movement (the journey) ₹100 onwards.

Scrip A had moved from ₹100 to ₹150, ₹175, ₹225, ₹235, ₹240 and then to ₹225.

Scrip B had moved from ₹100 to ₹175, ₹150, ₹215, ₹205, ₹285 and then to ₹250. Scrip B is more volatile.

Statistically, volatility is measured by standard deviation. Standard deviation measures the risk of any kind of investment. The more the volatility, the more the risk.

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Factoring risk

Most of the time, as investors, we look only at returns. We know that risk and returns are two sides of the same coin but still the subconscious mind refuses to factor in the risk.

We hear of “high risk, higher returns.”

Consider these two axioms (a) High risk, high returns (b) High returns, high risk.

Which one is more appropriate? Our immediate choice would be the first one. But think a little deeper, the second will seem more appropriate.

The additional thinking that was needed was to get the real answer from the subconscious mind.

Quite often in my talking assignments, I pose this question to the members of the audience: “How many of you can take a lot of risks?” Many hands go up.

Then, I ask the second question: “Of all those who have put their hands up, those who are at ease losing money can put their hands down.”

Now, all those who have had their hands up would be the ones saying, “We can take risks but do not like losing money.”

My next question to those individuals whose hands are still up would be: “You can take a lot of risks but are not comfortable losing money. What is your definition of risk?”

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Remember one very important fact: No one is risk averse, everyone is loss averse. The pleasure of making money (profit) is relatively lower than the pain of losing money.

Measuring volatility risk — i.e. standard deviation — entails within itself a measurement of all risks. The movement of price would be due to various factors — it could be situations and events within or outside the organisation.

The more the volatility, the more the chances of losing money. Speculators like to embrace volatility; investors want steadiness.

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Also, it has been observed that the longer an investor stays invested, the lower will be the impact of volatility. Investors who are disciplined gain the most. Investors who invest systematically — through SIPs — are the ones who benefit because they capitalise on volatility.

Going further, before investing do not seek information only on returns, look into both the risk and return possibilities.

Instead of simply looking at the past performance of that investment, be it gold, stocks, or mutual funds, ask for an update on its price movement.

(The writer is a financial planner and author of Yogic Wealth)

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