Investment Risk and Risk Management
Naming and measuring risk
Separate systematic risk (market, interest rate, inflation, currency, political/regulatory) - undiversifiable - from unsystematic risk (business, credit, liquidity, default), which diversification can reduce. Investors face interest-rate risk, reinvestment risk, credit risk, inflation risk, liquidity risk, longevity risk, and opportunity risk. For bonds, duration approximates the percentage price change for a 1% change in yield: a duration of 7 implies roughly a 7% price drop if yields rise 1%.
Risk-adjusted measures: standard deviation captures total volatility; beta captures sensitivity to the market (systematic risk only); the Sharpe ratio divides excess return by standard deviation (total risk); Treynor divides excess return by beta. Alpha is the return not explained by benchmark exposure.
Traps. Beta says nothing about company-specific risk. Variance is standard deviation squared - do not mix them. A high Sharpe ratio from a short track record is statistically weak. Distinguish risk tolerance (attitude) from risk capacity (ability to absorb loss); questionnaires measure the former.
Worked example. Portfolio return 9%, risk-free rate 3%, standard deviation 12%: Sharpe = (9 − 3) ÷ 12 = 0.50. If beta were 1.2 instead, Treynor = (9 − 3) ÷ 1.2 = 5.0. Higher is better in both, but they measure different risk definitions.