Equity Risk

What is Equity Risk?

Equity Risk is the risk that one’s investments will depreciate due to stock market dynamics causing one to lose money.

Equity risk, at its most basic and fundamental level, is the financial risk involved in holding equity in a particular investment. Although investors can build equity in various ways, including paying into real estate deals and building equity in properties, equity risk as a general term most frequently refers to equity in companies through the purchase of common or preferred stock. Investors and traders consider equity risk in order to minimize potential losses in their stock portfolios.

The measure of risk used in the equity markets is typically the standard deviation of a security’s price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as “risk”, some economists prefer other means of measuring it.

One basic way to limit equity risk is with diversification of stocks. Many professionals encourage investors to hold several stocks in order to provide diversification. The idea is that, if one stock experiences a sudden and significant decline, it will affect the portfolio less if additional stocks or equities are involved. Recently, some experts have been coming out with a more extreme call for diversification, urging the average investor to own at least 30 or more stocks.

Another way to avoid equity risk is in more specific diversification of the types of equities that the investor owns. For example, holding stock in various “sectors” like energy, technology, retail, or agriculture, helps with lowering equity risk. So does buying into a basket of global stocks, rather than keeping all stock investments rooted in the same national economy. All of these methods help investors to balance out their stock purchases and lower the risk that their total values will experience sudden price drops.

Equity risk premium

The equity risk premium is the difference between the rate of return of a risk-free investment and the rate of return of an individual stock over the same time period. Since all investments carry varying degrees of risk, the equity risk premium is a measure of the cost of that risk.

Equity risk premium is defined as “excess return that an individual stock or the overall stock market provides over a risk-free rate.” This excess compensates investors for taking on the relatively higher risk of the equity market. The size of the premium can vary as the risk in the stock, or just the stock market in general, increases. For example, higher risks have a higher premium. The concept of this is to entice investors to take on riskier investments. A key component in this is the risk-free rate, which is quoted as “the rate on longer-term government bonds.” These are considered risk free because there is a low chance that the government will default on its loans. However, the investment in stocks isn’t guaranteed, because businesses often suffer downturns or go out of business.

To calculate the equity-risk premium, subtract the risk free rate from the return of a stock over a period of time. For example, if the return on a stock is 17% and the risk-free rate over the same period of time is 9%, then the equity-risk premium would be 8% for the stock over that period of time.

The equity risk premium is used in the capital asset pricing model (CAPM) to establish the valuation of invested shares in a diversified portfolio. For the business trying to attract capital, it may use a variety of tools to manage the market’s expectations of the equity risk premium, such as stock splits and dividend yields.

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