How to Measure a Stock’s Risk

By Alan Fleisig

Most eternal questions are best left to philosophers. The eternal question of how to measure the risk of investing in a specific stock, however, has been pondered by investors, economists, brokers and armchair stock analysts for at least as long as public company stocks have been traded. There are two big sources of risk: business risk and market risk.

Business Risk: What a company is – what it makes, what it owns, how it handles its finances, its future sales prospects – is one aspect of a company’s potential stock price. We call the possibility of a change in a company’s underlying business causing a decline in that company’s stock price business risk. While there are many relevant trends and indicators an investor can look at – changes in sales, expenses, employees, debt and so on – it can be hard, if not impossible, to quantify an individual company’s business risk.

Market Risk: The other critical aspect of measuring an investment’s risk concerns the stock’s performance on the stock market itself. Many factors not in a company’s direct control – investor sentiment, economic performance, volume of trading and so on – influence returns. When we talk about market risk, we refer to the possibility of a stock’s price increasing or declining without regard to its underlying business fundamentals.

Past Risk: The past (or “historical”) market risk of a stock can be quantified. Analysts use a measure they call beta, which is the ratio of a stock’s day-to-day change in price over time, compared to that of an index, typically the S&P 500. Generally speaking, stocks with a higher beta are considered riskier, because their price has demonstrated a historical tendency to fluctuate more widely than the index. Over the long run, however, high beta stocks may also have the potential to produce bigger returns.

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