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Risk and Volatility
Lesson 1
Measuring Risk
Risk and Volatility
Aim:
 What causes an investment to not
achieve the results we expect?
Do Now:
 Identify the risks a person takes
between when he or she walks out the
door in the morning for work and
returns later that day.
Risk and Volatility
 Do Now answer: The person could get
into a car accident. He or she could slip
and fall while walking. The food eaten for
lunch may be bad. None of these is
expected, but there is a risk they could
happen.
Risk: The Volatility of Returns
Investments are uncertain. The
actual cash flows that we receive
from a stock or bond investment
may be different than the
expected cash flows.
The factor that causes the
inequality between realized
return and expected return is
risk.
Risk: The Volatility of Returns
Realized Return: The return that is actually
achieved from an investment.
Risk: The Volatility of Returns
Expected Return: The return an investor
anticipates generating from an investment.
If the cash flows received
from a stock or bond
investment are lower than
expected, the
realized return <
expected return.
If the cash flows received
are higher than the
investor expected, the
realized return >
expected return.
How is Risk Measured in the
Financial Markets?
Standard Deviation: How much the prices move
around the mean, or average price. A statistical
measurement that highlights historical volatility
(fluctuation).
The normal distribution of a set of
data is a “Bell Curve”. A bell curve
depicts a data set in which the
majority of the data falls close to the
mean. The further the distance from
the mean, the fewer the data points
will lie under the curve (in the tails).
Risk Measurement
When returns are normally distributed, an
individual return will fall within one standard
deviation of the mean about 2/3 of the time (the
grey area), which is 66.8% of the time. 94.5% of
the time, returns are two standards deviations from
the mean (the red area).
Risk Measurement
High standard deviation signifies a high
degree of risk.
If a stock is not very volatile
If a stock is volatile (higher
risk), it has a high standard
deviation and the bell curve is
relatively flatter. This is
because the data is spread
more evenly under the curve.
(low risk), it has a low
standard deviation and then
the bell curve is steeper. This
is because an even higher
majority of the data lies near
the mean.
Example of Volatility
Volatility is the degree to which a stock’s price
fluctuates. More fluctuation means the stock is
highly volatile and less fluctuation means a stock is
less volatile.
Example of Volatility
There are several causes that result in realized return to
be unequal to expected return. These are called risks.
They both start at
$100 and end at $100.
However, Stock B has
much higher historical
volatility than Stock A.
Each graph shows the historical
prices of two different stocks over
the last 12 months.
Lesson Summary
1. What is term we use for uncertainty?
2. If we were to plot a variety of possible
outcomes for what an investment will be
worth, what shape should we expect?
3. What do we call the variation from the mean
that covers about 2/3rds of the outcomes.
4. When a stock’s price history is more volatile
than normal, what does this mean?
5. What causes an investment to not achieve
the results we expect?
Web Challenge #1
Challenge: The classic “bell curve” represents
the graphical layout of the potential outcomes
for the value of an investment. It is used in
other areas, such as displaying the range of
student scores on an exam.
Including this example (if you wish), research
three fields where the use of the bell curve is
common. Provide an example of an actual bell
curve showing real outcomes. Identify the
industry and the meaning of the industry bell
curve you identified.
Web Challenge #2
Challenge: Find an investing risk tolerance quiz
on the Internet and take it. Describe why you
believe the result does or doesn’t accurately
reflect you and your outlook. Also, identify any
recommendations made about the appropriate
types of investments for you.
Web Challenge #3
Q: Should we be concerned for outcomes at
the very ends of the bell curve?
 A: Yes. Even though they have a small
chance of occurring, if they do occur their
effects can be catastrophic!
 Challenge: Research the book “The Black
Swan” by Nassim Taleb. Read a synopsis of
the book. Identify and describe three of the
main points of the book, including what a
Black Swan is.