V.11:1 (45-50): Risk Assessment For Security Analysis by Lloyd Silver

Risk Assessment For Security Analysis by Lloyd Silver

Assessing the risk in a security is an essential part of the investment process. Here, then, are the advantages and disadvantages of two common risk measures: variance and beta. Further, Lloyd Silver introduces a relatively unknown, yet effective, risk measure called lower partial moment and finishes with a method of comparing securities.

Before discussing how to measure risk in a security, it is important to explain exactly what risk is and why it is important to the investment process. Three possible conditions are present when forecasting security returns: certainty, risk and uncertainty. Certainty is when the investor knows the exact return of his or her investment with 100% probability. This condition is most likely to be present in 90-day Treasury bills when held to maturity. The investor knows the rate of return and because it will be held to maturity, there will be no capital gain or loss due to interest rate fluctuations.

Risk is defined as the chance that the actual return from an investment may differ from the expected return. The more variable the range of possible returns is, the greater the risk and vice versa. The condition of risk is present in most securities. Investors have a forecast of expected future returns, but none of the returns can be guaranteed.

Uncertainty is when the investor has little or no idea about the expected future returns of the security. This condition is usually not theoretically present in an investment situation; most people would not invest in a security if no forecast could be made about the future returns of the tradable whatsoever. However, because most forecasts are completely subjective anyway, uncertainty as a term can often be used interchangeably with risk.