Basically, stocks are subject to two types of risk - market risk and nonmarket risk. Nonmarket risk, also called specific risk, is the risk that events specific to a company or its industry will adversely affect the stock's price. For instance, an increase in the cost of oil would be expected to adversely affect the stock prices of the entire oil industry, while a major management change would only affect that company. Market risk, on the other hand, is the risk that a particular stock's price will be affected by overall stock market movements.
Nonmarket risk can be reduced through diversification. By owning several different stocks in different industries whose stock prices have shown little correlation to each other, you reduce the risk that nonmarket factors will adversely affect your total portfolio.
No matter how many stocks you own, you can't totally eliminate market risk. However, you can measure a stock's historical response to market movements and select those with a level of volatility you are comfortable with. Beta and standard deviation are two tools commonly used to measure stock risk.
Beta, which can be found in a number of published services, is a statistical measure of the impact stock market movements have historically had on a stock's price. By comparing the returns of the Standard & Poor's 500 (S&P 500) to a particular stock's returns, a pattern develops that indicates the stock's exposure to stock market risk.
The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market and has a beta of 1. A stock with a beta of 1 means that, on average, it moves parallel with the S&P 500 - the stock should rise 10% when the S&P 500 rises 10% and decline 10% when the S&P 500 declines 10%. A beta greater than 1 indicates the stock should rise or fall to a greater extent than stock market movements, while a beta less than 1 means the stock should rise or fall to a lesser extent than the S&P 500. Since beta measures movements on average, you cannot expect an exact correlation with each market movement.
Calculating your portfolio's beta will give you a measure of its overall market risk. To do so, find the betas for all your stocks. Each beta is then multiplied by the percentage of your total portfolio that stock represents (i.e., a stock with a beta of 1.2 that comprises 10% of your portfolio would have a weighted beta of 1.2 times 10% or .12). Add all the weighted betas together to arrive at your portfolio's overall beta.
Standard deviation, which can also be found in a number of published services, measures a stock's volatility, regardless of the cause. It basically tells you how much a stock's short-term returns have moved around its long-term average return. The most common way to calculate standard deviation is to figure the deviation from an average monthly return over a three-, five-, or 10-year period and then annualize that number. Higher standard deviations represent more volatility. In statistical terms, 68% of the time the stock's range of returns will fall within one standard deviation of the average return, while 95% of the time the stock's range of returns will fall within two standard deviations.
Consider this example. Assume you own a stock with an average return of 10.2% and a standard deviation of 15%. 68% of the time you can expect your return to fall within a range of -4.8% to 25.2%, while 95% of the time you can expect your return to fall within a range of -19.8% to 40.2%. (This example is provided for illustrative purposes only and is not intended to project the performance of a specific investment.)
These two measures can provide important information about a stock's volatility. If your portfolio is riskier than you realized, you might want to take steps to reduce that risk. When investing, you might want to take a look at a stock's risk first.