Guest post by Gennaro Cuofano @ www.becomefinancialanalyst.com
The Oxford Dictionary defines risk as:
“A situation involving exposure to danger” and it goes on “The possibility that something unpleasant or unwelcome will happen.”
Thus we want to define what is danger and what is this unpleasant thing we want to avoid. A first obstacle stands in the way of defining risk. In fact, each of us seems to have a different perception of what danger is. For instance, you may be a firefighter that is so brave to jump into homes on fire and save people and still be very fearful when it comes to investing!
In addition, in the investing world there is a term used behavioral economists, which is “loss aversion.” In short, it seems that we perceive losses way more than we actually perceive gains. This bias was first elaborated and verified by Amos Tversky and Daniel Kahneman. In other words, a 10$ gain is perceived more than twice less satisfactory of a loss of the same amount. This seems to be a built in bias. Thus, we can do our best to define risk, although our definition may not be perfect.
Since, risk is different according to the perspective of the investor, A. Damodaran proposes a useful approach, which is that of the “marginal investor.” In short, to define risk you have to define the marginal investor first. But who is this marginal investor?
The marginal investor is the person or institution that at any time may hold the stocks of a company and therefore also influences its prices. The next step is to identify the marginal investor. How? Well, we have just to look at the ownership structure of our target company. For instance, let’s look at who the marginal investors are for Apple:
For instance, Apple’s main shareholders are Institutions and Mutual Funds. In fact, insiders hold just a tiny part of Apple’s issued shares. Thus, we can easily assume that Apple’s marginal investors are well diversified. This means that they will have a lower risk compared to a non-diversified investor. Why?
Let’s assume that you have all your capital invested in one company. What happens if that company goes bankrupt? You will lose all your wealth, wouldn’t you? Conversely if you have your eggs in different baskets, if one basket falls you will still have the other eggs. If you are an individual you can diversify your financial risk by investing in different stocks or for instance in a stock index. What about a business? How can a business diversify (thus reduce) its risk exposition?
To answer to this question we have to analyze the several components of risk. To know more about risks and how to measure it, check out the corporate finance simplified manual here.