If you have been investing in the stock market, you will know that it may be risky to put your money into stocks because share prices can be unpredictable.
While it is easy to say that the stock market will always have its ups and downs, it is actually difficult to manage consistency in stock prices, especially when your emotions are involved.
But as much as there are risks from uncertainties in price movements, there are also opportunities to profit from them. So, if you want to take your chances in stocks, how much risk will you be willing to take?
Taking risk can make you lose money but when you take a calculated risk, you can lessen your losses and increase your chances of winning.
One way to calculate your risk is to estimate the volatility of a stock by computing its standard deviation.
In finance, we use the standard deviation to measure the variability of a stock’s historical returns. The greater the variance between the return of a stock and its average, the higher the standard deviation should be.
The average return, as we know in statistics, is the mean, which is the minimum expected return of a stock.
If a stock has a high standard deviation compared to others, it simply means that its actual returns tend to differ largely from its expected return, making it relatively more volatile and riskier.
Let’s take the case of Security Bank (SECB) and ISM Communications (ISM). These two stocks have similar 10-year average returns of 34 percent a year.
At first glance, the two may seem not so different from each other they have the same expected returns.
But if you will look at each stock’s historical volatility, ISM emerges three times more volatile than SECB with a standard deviation of 1.16 percent compared to the latter’s 0.50 percent.
Because ISM has a higher standard deviation, the stock tends to spike more compared to SECB, which is likely to move mostly within a limited range.
The standard deviation can also be used to identify share price volatility instead of returns. Let’s say we take the sample of daily price changes of SECB and ISM for the last six months.
We will see that ISM comes out more volatile with standard deviation of 23.6 percent compared to SECB with just 8.7 percent. This means that if you want to take more risks for higher returns, you can trade ISM for a bigger payoff.
Following a statistical rule in normal distribution, there is 68 percent chance that you can gain as much as 23.6 percent from ISM, but if you make the wrong move, you can also lose by the same percentage.
On the other hand, if you are more conservative, you can buy SECB, which offers a lower return of 8.7 percent but lower downside risk, too.
Depending on your risk preference, you can create a portfolio of stocks wherein you can balance your allocations between the high volatility and low volatility stocks to achieve your investment objectives.
If you are buying PSE index stocks, some of the low-volatility stocks that you can consider based on daily returns for the past 180 days are Ayala Corp., which has standard deviation of 3.1 percent; Meralco, 3.4 percent; SM Investments, 4.1 percent; Aboitiz Power, 4.8 percent and Puregold, 5.5 percent.
The high volatility PSE index stocks, on the other hand, are Bloomberry, which has high standard deviation of 15.5 percent. This is followed by JG Summit with 12 percent; Aboitiz Equity, 11.9 percent; GT Capital, 11.7 percent; and ICTSI, 11.2 percent.
If you want to consider the non-PSE index stocks, those with lowest standard deviations are Asia United, 1.1 percent; Rockwell, 2.1 percent; Shang Properties, 2.2 percent and Eagle Cement, 2.8 percent.
Interestingly, those with the highest standard deviations are mostly speculative stocks that include Now Corp. with 90 percent; Premiere Horizon, 52.8 percent; Xurpas, 46.3 percent; EasyCall, 45.6 percent and Asiabest, 44 percent.
While measuring risk in terms of standard deviation can be helpful in identifying the right stocks to invest, bear in mind that the estimates are based on historical data and do not necessarily imply future performance.