How do I Evaluate Stock Risk?

Ron Davis

Stock risk can be divided into either systemic-systematic as well as specific, or unsystematic, risk. Systemic risk is the risk of the entire economy collapsing, and systematic risk is the risk of only the stock market collapsing. Specific risk is loss in one particular stock.

Diversification in stocks is one way to minimize risk.
Diversification in stocks is one way to minimize risk.

If the investor knows that either the economy or the stock market is about to collapse, he will not want to take any stock risk whatsoever. Without that knowledge, he can do his best to assess the risks of a particular company, and he can then diversify away some of the risk. A reasonable starting point is to estimate the future prospects of the company’s main revenue source. For example, after World War II the aircraft industry blossomed, as did the trucking industry. Growth in those industries provided so much competition for railways that they became poor investments.

Review of the financial condition of a company is a normal step in assessing stock risk. Publicly owned corporations are required to file audited financial statements with regulators in all major Western countries, making financial information available. Unfortunately, this information can be misleading. It is possible for companies to employ creative accounting or reporting strategies that mischaracterize the financial health and stability of a company.

Reading analytic reports of a company can also assist in evaluating risk. Professional analysts consider their interviews of corporate management to be very valuable. They believe they can use the information gathered in these interviews to assess the company’s future prospects, and in turn the associated stock risk. There is some risk involved in relying on analyst interviews, however, because sometimes company management block the publishing of negative information.

Perhaps the best approach to controlling stock risk is through diversification. The idea behind diversification is that no one can successfully choose stocks that will out-perform the overall market, and no one is always able to avoid unanticipated stock risk. By having stocks in several companies divided up among the different sectors of the stock market, one can earn a respectable return without the worry of one company doing poorly. A different approach to controlling stock risk is to buy the stock market as a whole, for instance, through the purchase of exchange traded funds (ETFs). It is possible to increase portfolio diversification beyond just the stock market by investing in a commodities futures fund and in real estate. This avoids single stock risk and, simultaneously, reduces the portfolio exposure to systematic risk.

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