Imagine you had $100,000 dollars, and all your friends and YouTube gurus told you to invest them in Bitcoin last year. You took their advice, and you did. At the current price of Bitcoin, your $100,000 would be worth around 30,000$. That's because Bitcoin and other types of cryptocurrencies are risky assets. A risk asset is an asset that has high volatility in price.
Bitcoin and other cryptocurrencies are just some of the risky asset classes. Stocks can be risky as well. However, some assets are still safe and guarantee safe returns. Yep, you heard that right; some assets bear minimum or no risk at all.
Risky assets can either help you build generational wealth or destroy your entire wealth, and this article will explain how all this works! Ready? Then keep on reading!
Risk Asset Definition
Before we dive into risk asset definition, let's consider what an asset is.
An asset is something of monetary value that provides a stream of income or benefits to its owner.
For example, owning real estate properties is an asset. That's because real estate properties could be used for renting out and receiving income flow every month.
This is an example of an explicit payment as you receive monthly monetary flow from renting your real estate property.
There is also the implicit form through which you receive monetary value from your asset.
Considering that the price of rental properties has experienced a significant increase in value, you decide to sell one of them. The profit you make is a capital gain.
That is, the monetary benefits of owning such an asset are realized once the asset is sold.
Capital gains occur when the asset increases in value.
A capital loss occurs when the asset decrease in value.
An asset could be subject to either capital gains or losses, which gives rise to risky assets.
A risky asset is an asset that provides uncertain monetary flow to its owner.
While owning assets could be very beneficial and enable you to get generational wealth, it could also be risky, leading to capital losses.
Owning property such as an apartment and lending it out is beneficial in terms of the monthly income flow you receive. However, there are risks associated with it.
Your tenants could lose their job, be unable to pay rent, and stay in your apartment until they get an eviction notice. The entire eviction process requires lawyer fees and time spent in court.
Additionally, the value of the property could decrease due to external factors. A financial crisis like the one in 2008 could plummet the price of your house, leading to capital loss.
In addition to risky assets, there are also risk free assets.
Risk free assets, as the name suggests, are assets that bear minimal amount of risk.
Short-term U.S. Government bonds, known as Treasury bills, are a great example of riskless assets. The only way these assets will fail is if the U.S. government defaults, which is highly unlikely to happen.
However, you should be aware that risk free assets provide way lower returns than risky assets.
Return refers to the total monetary value one receives from owning an asset.
Risk Asset Formula
The risk asset formula is the fraction of money invested in risky assets multiplied by the standard deviation of the asset.
To reduce risks, an investor decides to invest their money between a risky asset and a non-risky asset.
Let's consider an investor who invests in Treasury bills and in the stock market.
The expected return on the investor's portfolio will be as follows:
\( R_p = bR_s+(1-b)R_t \)
Where \(b\) is the portion of the money invested in stocks and \((1-b)\) is the portion of the money invested in T-bills.
\(R_t\) is the expected return on T-bills, and \(R_s \) is the expected return on stocks.
Imagine that T-bills had an expected return of 3% and the stock market had an expected return of 9%.
What would the expected return on the portfolio be if the investor invested 1/3 of his money in T-bills and the other part in stocks?
\( R_p = bR_s+(1-b)R_t \)
\( R_p = (\frac{2}{3})\times0.09+(\frac{1}{3})\times 0.03 \)
\( R_p = 0.06+ 0.01 \)
\( R_p = 0.07 \)
\( R_p = 7\% \)
The return on the investor's portfolio is 7%. What about the risk the investor faces?
The way to measure the risk the investor faces is by using the standard deviation.
Standard deviation measures how much the return deviates from its mean.
Think of it as the deviation from the asset's usual (standard) return. If the asset has a high standard deviation, it's riskier.
We will denote the standard deviation of an asset by sigma.
The risk that the investor faces in his portfolio is:
\( \sigma_p = b\times\sigma_s \)
Where \( \sigma_p\) is the standard deviation of a portfolio and \(b\) is the portion of the money invested in stocks. Since the risk free asset has zero standard deviation, the only one that matters for the investor now is the standard deviation of the stock market - \( \sigma_s\).
Let's reconsider the formula of the expected return on the investor's portfolio.
\( R_p = bR_s+(1-b)R_t \)
Using some basic math, we can rearrange the formula.
\( R_p = bR_s+(1-b)R_t = bR_s + R_t - bR_t = R_t + b(R_s-R_t)\)
From the formula of risk on the investors' portfolio, we know the following:
\( b=\frac{\sigma_p}{\sigma_s} \).
Therefore,
\( R_p=R_t + \frac{(R_s-R_t)\times\sigma_p}{\sigma_s} \)
This equation is a budget line. It's a function that describes what happens to the returns on a portfolio when there is a change in risk.
Fig. 1 - Budget line of an investor choosing between T-bills and stocks
Figure 1 shows the budget line of an investor who chooses to invest between T-bills and stocks. The budget line represents the investor's choices between risk and the expected return on a portfolio.
When risk increases, the expected return on his portfolio increases as well. But to have his expected returns increase, the investor faces much more risk. Hence, he is exposed to more significant losses. This is known as the price of risk.
Price of risk is the extra risk an investor must incur to enjoy a higher return on their portfolio.
If the investor were risk-verse, the investor would choose to invest all their money into T-bills and generate an expected return of \(R_t\), as \(b=0\).
Risk-averse is a term that is used to describe the investors' dislike towards risk.
If the investor wanted some risk, meaning they are risk-loving, they would invest all the money into stocks where \(b=1\). The expected return on this investor's portfolio would be \(R_s \).
Dive deeper into this topic in our article:- Risk and Return Trade-Off.
Risk Asset Examples
There are many examples of risky assets. Usually, assets that are risky generate higher returns as well as higher losses. A famous saying among investors is that 'the higher the risk, the higher the return'.
Cryptocurrencies are an example of the asset that has generated the highest return over the last decade. Many people have found themselves millionaires after investing a couple of thousands in Bitcoin during its early days. In the same way, many people lost their life savings when the crypto market crashed.
To put it in perspective, at the moment of writing this explanation, Bitcoin has a standard deviation of 3.791. On the other hand, the S&P 500, which is an index that tracks the 500 biggest companies in the United States, has a standard deviation of 1.672. That means that Bitcoin is twice as risky as the S&P 500, as the deviation of Bitcoin's price from the average price is twice as much as the S&P 500's.
Gold, which is a relatively safer investment, does not generate as high a return as stocks or crypto and has a standard deviation of 1.053.
Risk Asset Management
One of the main risk asset management strategies involves having the money invested in different asset classes to mitigate the risk an asset carries.
For example, if you decide to invest in real estate, you should not put all your eggs in one basket and make your return contingent on the upside of the real estate market.
Instead, it would be best to consider having some money invested in T-bills that carry lower risk and some other money invested in the stock market. If one of these asset classes goes down, you will make up for the loss from the other asset classes.
Fig. 2 - Managing risk
Figure 2 illustrates how an investor manages risk faced in their portfolio by choosing between different levels of risk and different levels of expected return. The portfolio of this investor consists of stocks and T-bills.
- If the investor wanted to go full-on risk and maximize their return, they would choose to invest all their money in stocks and get a return of \(R_s\).
- If they didn't want to take risks and get a guaranteed return, the investor chose to invest all of their money in T-bills at \(R_t\).
However, the investor manages the risk by investing parts of their money in T-bills and the other part in the stock market.
There are three indifference curves in the diagram above, and each curve details different combinations of risk and return that result in the same level of utility for the investor.
As risk is undesirable for the investors, the indifference curves slope upward. Therefore, a higher level of risk is associated with a higher expected return level to leave the investor with the same level of utility.
The indifference curve shows how an individual chooses between market baskets while being equally satisfied.
To learn more about them, check out our article:- Indifference Curve.
Amongst the three curves, indifference curve I3 provides the highest degree of satisfaction, whereas indifference curve I1 provides the least amount of satisfaction. In other words, the investor would rather be on indifference curve I3 than any of the other three indifference curves.
However, as I3 does not intersect with the budget line, the investor cannot choose indifference curve I3. The investor can choose I1, but I2 gives the investor a higher level of utility, and therefore the investor decides to choose I2.
The point where the I2 intersects the budget line is the point that reveals the expected returns on the investor's portfolio and the standard deviation of his portfolio, in such a case, \(R_e\) and \(\sigma_e\).
Types of Asset Risk
There are three main types of asset risk: lower risk, moderate risk, and higher risk.
Lower risk are the type of assets that are associated with lower risk and lower return as well.
For example, cash is a lower-risk asset. In addition, T-bills and gold are lower-risk assets.
Moderate-risk assets are assets that are associated with moderate risk and moderate return.
For example, some of these types of asset classes include property and the stocks of the S&P 500.
Higher risks are assets that have higher returns but, at the same time, are riskier than other assets.
Figure 3 illustrates some types of assets and their degree of risk accordingly.
Risk Asset - Key takeaways
- An asset is something of monetary value that provides a stream of income or benefits to its owner.
- A risky asset is an asset that provides uncertain monetary flow to its owner.
- Return refers to the total monetary value one receives from owning an asset.
- Price of risk is the extra risk an investor must incur to enjoy a higher return on their portfolio.
References
- Macro Axis, Bitcoin Standard Deviation, https://www.macroaxis.com/invest/technicalIndicator/BTC.CC/Standard-Deviation?PageSpeed=noscript
- Macro Axis, S&P 500 Standard Deviation, https://www.macroaxis.com/invest/technicalIndicator/%5EGSPC--Standard-Deviation#:~:text=SP%20500%20has%20current%20Standard,field%20of%20investing%20and%20finance.
- Macro Axis, Gold Standard Deviation, https://www.macroaxis.com/invest/technicalIndicator/GLD--Standard-Deviation
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