Session 05 | What Is Risk? | NRICHMINDS Stock Market Investing

Reading

Background

Before you can become an informed investor, you must understand that every investment carries risk. Each investor must determine their risk tolerance: are they a conservative, moderate, or speculative investor? A number of factors, including age and financial stability, are important elements in determining a person's risk tolerance.

Conversely, all stocks carry some risk, and the more information an investor has about a stock's risk level, the better that investor can determine whether it's compatible with their personal risk tolerance.

A stock's beta number is one way investors can estimate the level of a stock's risk. It should be stressed that no measure of risk or volatility is foolproof or consistently accurate. Beta shows how a particular stock's price moves in relation to the market as a whole. There are betas for individual stocks and for entire industries. A beta number greater than 1 is generally considered higher risk.

A beta of 1 indicates that the stock's price should move with the overall market: if the market goes up 20%, the stock's price can be expected to go up about 20%; if the market is down 10%, the stock may be down about 10%. Beta reflects a stock's performance over months, not days.

A beta of more than 1 indicates a stock that is more volatile than the market. For example, if the market goes up 10%, the stock may increase 15%. In short: the higher the beta, the more volatile the stock; the lower the beta, the more stable the stock compared with the market.

Key Terms

Vocabulary

Beta: A calculation that helps measure the level of risk in investing in a stock.

Price/Earnings Ratio (P/E Ratio): The ratio of a stock's price per share to its earnings per share.

Risk: The chance of losing all or part of the value of an investment. Risk can be divided into three categories:

CONSERVATIVEFixed income and preferred stocks are considered conservative.

MODERATEGrowth stocks, particularly young companies with great potential, are considered moderate risk.

SPECULATIVEStocks that are highly unpredictable. Many dot-com stocks were highly speculative, with incredible highs and devastating lows.

Risk Tolerance: An investor's ability to accept loss of some or all of the money they've invested, based on factors including age, financial stability, and how much time there is before the invested funds are needed for other purposes.

Volatile / Volatility: The potential unpredictability or instability of a stock. A volatile stock is a risky stock, one that can go very high or very low.

Goals

Performance Objectives & Subject Areas

By the end of this session, you will be able to:

Define and illustrate the three major kinds of risk.
Examine companies and determine the risk involved in investing in them.
Research two companies and decide the level of risk you'd take by investing in them.
Write a persuasive letter motivating or discouraging an investor from purchasing stock in a researched company.
Solve decimal multiplication problems.

Subject areas: Economics, Technology/Research, English Language Arts (Writing), Mathematics, Business, Social Studies.

Materials: Chart paper, internet or newspaper access, Activity Sheets 1–4.

Warm-Up

Springboard Activity

Jamie wanted advice about the best way to make money on money she received for her birthday.

Her brother told her, "Buy a lottery ticket. It may be risky, but you could become a millionaire."
Her grandmother said, "Put it under your mattress and save it for a rainy day."
Her best friend advised her, "Buy stock in Sunoco, gas prices are always in the news."
Her aunt said, "Put it in a savings account and you can earn 1% interest a year for the next 20 years."

Discuss: Which investment seems the best? What do you think, and why? Discuss and define "risk."

According to the Random House College Dictionary, risk is "exposure to the chance of injury or loss."

Guided Discussion

Low Risk, High Risk, and the Three Categories

Ask: How do you think risk applies to investing? What does Jamie need to learn about investing to make the best decision?

Low risk = low return
High risk = high return, low return, or loss

Remember the correlation: low risk usually means low profit; high risk may mean high profit or big losses.

CONSERVATIVE (LOW)Means taking limited risk on secure stocks and fixed income investments. Fixed income stocks are generally stocks that pay higher-than-average dividends (4% or higher). A dividend is money paid out to the owner of a stock based on the profit of a company. The value or price of the stock does not change quickly.

MODERATEGrowth stocks, stocks that grow faster and higher (in value and price) than stocks of other companies with similar sales and earnings, are considered to be of moderate risk.

SPECULATIVE (HIGH)Stocks that carry major risk on investments with unpredictable results, but the potential to earn very high returns. When investing in speculative stocks, the investor must realize that while there is a chance of great returns, there is also the possibility of great loss.

Activity Sheet 1

Conservative, Moderate, or Speculative?

Decide whether each investment below is a conservative, moderate, or speculative risk, then reveal a model answer. No answer key was provided for this sheet, so these are my own reasoned answers based on the categories defined above; reasonable arguments could shift a couple of these, and that's worth discussing in class.

INVESTMENT 1

Company Clockwork makes clocks. Compared with other clock-making companies, Company Clockwork has the highest revenue and earnings, but low profits. Its earnings have grown 15 percent over the past 5 years, versus a 10 percent average for other clock companies over the same period.

MODERATE Company Clockwork is out-growing its peers (15% vs. 10% earnings growth), which is the defining feature of a growth stock, and growth stocks are classified as moderate risk. Its low profits despite high revenue add some uncertainty (it may be spending heavily to fuel that growth), but there's nothing here suggesting the wild unpredictability of a speculative stock, nor the stability of a fixed-income conservative one.

INVESTMENT 2

Jax Company provides gas and electric to your area. The stock pays an annual dividend of $4 per share. You own 200 shares, so the company pays you a yearly dividend of $800. This is a fixed income stock.

CONSERVATIVE The problem tells you directly that this is a fixed income stock, and fixed income stocks are the textbook definition of conservative risk. A steady utility company with a reliable dividend is exactly the low-volatility, income-focused profile this category describes.

INVESTMENT 3

You learn about a new drug that supposedly makes children smarter. You've never heard of the drug manufacturer, but you decide to invest anyway, with no other information.

SPECULATIVE An unknown company, an unproven and frankly implausible-sounding product, and a decision made with no real information: this is the definition of a highly unpredictable, high-risk, high-potential-reward investment. There's no earnings history, no track record, nothing to anchor an expectation of stability.

INVESTMENT 4

Interior Electric announces it is creating an all-electric car, but it hasn't come out yet. Based on the news, its stock price has increased 20% in one month.

SPECULATIVE A 20% price jump in a single month, driven entirely by an announcement about a product that doesn't exist yet, with no earnings or sales data mentioned at all, is a classic hype-driven speculative move. The price is running ahead of any proven results, which is exactly the kind of unpredictability this category describes.

INVESTMENT 5

ALLON oil company's profits have almost doubled this year. The price of the stock has gone up from $48 to $56 over the same period.

MODERATE The price move here, (56 − 48) ÷ 48 × 100 = 16.67%, is real and backed by actual doubled profits, not just hype, which argues against calling this purely speculative. A company growing this fast is also not the stable, dividend-paying profile of a conservative stock, so moderate (growth stock) is the best fit. A reasonable counter-argument: oil is a commodity-driven industry where prices can swing sharply on factors outside the company's control, so some would push this toward the more speculative end of moderate. Worth debating in class rather than treating as settled.

Activity Sheet 2

To Risk or Not to Risk?

Risk tolerance is personal. Based on age, salary, financial obligations, and family situation, decide whether each person's risk tolerance is Low (L), Moderate (M), or High (H). As with Activity 1, no answer key was provided, so these are reasoned model answers, not a fixed official key.

1. Teddy, 26

Just got a new job at a much higher salary. Single, no loans, expects a raise within six months. Wants to invest some of his new-found wealth.

HIGHYoung, no debt, no dependents, rising income, and a long time horizon before he'd need this money for anything specific. This is close to the ideal profile for a high risk tolerance.

2. Juanita

Single mother of two, ages 10 and 12. Saving for college; needs money for her first child in six years.

MODERATESix years is enough time to ride out some market ups and downs, but it's a real, fixed, non-negotiable obligation (her child's college fund), not disposable money. That combination points to moderate rather than high risk tolerance.

3. Bill, 62

Good health, wife has a low-paying job, children grown and independent. Retiring in three years.

LOWA three-year horizon to retirement, combined with a household that will soon depend more heavily on investment income, leaves little room to absorb a major loss. This calls for a low risk tolerance.

4. Tasha, 8

Her parents want to start a small investment portfolio for her, to use for college or a home someday.

HIGHWith a decade or more before this money is likely needed, there's a long runway to recover from any short-term downturns, which supports a high risk tolerance for this portfolio.

5. Monique & Harrison

In their forties, three children, a mortgage and some credit card debt. A small amount set aside for retirement at 65.

MODERATEA 20-plus year horizon to retirement argues for some real growth exposure, but existing mortgage and credit card debt reduces how much of a hit their finances could absorb right now. Moderate balances those two facts.

6. Devon

Also in his forties. Home paid off, good salary, no children. Wants to buy a beach condo in 10 years.

HIGHNo mortgage, no dependents, a good income, and a 10-year horizon. Devon has both the financial cushion and the time to take on meaningful risk.

7. Blair, 20

Nearly finished college, all costs covered by her parents, who've also promised her a house. Works weekends and summers; has saved several hundred dollars to invest.

HIGHA small amount of money, no urgent need for it, and a young age with major expenses (college, housing) already covered by her parents. Little to lose relative to her situation, and plenty of time, supports a high risk tolerance.

8. Sam, 35

Works as a cook, barely covers rent and groceries for his wife and baby. Inherited $2,000 from his grandmother.

LOWSam has essentially no financial cushion, and this $2,000 could matter a great deal to a family living paycheck to paycheck. This is a textbook low risk tolerance situation, regardless of his age.

9. Lisa, 27

Good job, few bills. Wants to take a year off to travel in Europe in five years. Has $5,000 to invest and will need $25,000 for the trip.

HIGH (with a caveat)Her personal situation, young, stable, few obligations, supports a high risk tolerance. But it's worth flagging plainly: turning $5,000 into $25,000 in five years requires roughly 38% annual growth, compounded, which is far beyond what any prudent, risk-adjusted strategy can reliably promise. A high risk tolerance doesn't mean the goal itself is realistic; a good discussion point is that this may be a case where the goal needs to change (save more, extend the timeline) rather than one where "more risk" can responsibly close the gap.

10. Henry, 68

Retired, very healthy, expects to live at least 20 more years. Received a $20,000 check when his pension fund dissolved. Gets Social Security and has a small amount of savings.

LOWThe conventional answer, and the one I'd lead with, is low: he's retired, living on Social Security and modest savings, and this $20,000 likely needs to last. But it's fair to note the counter-argument: a healthy 68-year-old with a 20-year horizon has more time than people often assume, and holding everything in ultra-safe assets risks losing purchasing power to inflation over two decades. A reasonable middle answer is low-to-moderate, weighted toward low given his limited other resources.

Activity Sheet 3

Research Guidelines

Each member of your Stock Market Game team must research two public companies to prepare for your team's stock selections. Use www.nyse.com or the companies' own websites (look for an "Investors" or "Investor Relations" link, often near the bottom of the homepage).

What is the 52-week high and low?
What is the P/E ratio?
What is the current price of the stock?
Explain what the company is and does.
Are there any new products the company plans to make public soon?
What impact does the condition of the economy have on the company's products and services?
What type of risk do you think you're taking by investing in this company? Why?
Based on your research, will you recommend this company to your team for potential investment? Why?

This activity calls for live research into two real, currently-public companies, so there's no fixed answer key to provide here. Whatever a student finds should be checked against the company's own investor relations page, since prices, ratios, and product plans change constantly.

Activity Sheet 4

Understanding Beta

A beta of one indicates that a stock's price moves exactly with the overall market. For example, if the market goes up 20%, the stock price goes up 20%; if the market goes down 10%, the stock goes down 10%.

A stock with a beta greater than one is more volatile than the market. The higher the beta, the more volatile the stock. A beta of less than one indicates the stock's price is more stable than the market.

Formula: (S&P % Change × Beta Number) × Cost per Share = Assumed increase / decrease per share.

Example: Company A has a beta of 0.5, price per share $50.00, and the S&P moved −4%.
(−0.04 × 0.5) × $50.00 = −$1.00

A company with a beta of 2.3, same price and same S&P move: (−0.04 × 2.3) × $50.00 = −$4.60. Notice the loss is much greater for the higher-beta company. If the S&P had moved up 4% instead, the gain would be much greater too.

Note: this does NOT mean the stock's value actually moved this much on that day. It assumes the stock moved based on its historical relationship to the market.

Part 1: Calculate the assumed increase or decrease per share for each company below.

Company	Beta Number	S&P 500 YTD % Change	Cost per Share	Increase/Decrease
Computer Week	1.06	−5%	$83.00	−$4.40
Inter Finder	2.8	+5%	$342.00	+$47.88
Tea Company	0.32	−4%	$35.00	−$0.45
Coffee Company	1.1	+4%	$37.00	+$1.63

Worked example for Computer Week: (−0.05 × 1.06) × $83.00 = −0.053 × 83.00 = −$4.40. Same method for each row. High confidence, since this is direct arithmetic using the formula given.

Part 2: Research three companies you're interested in investing in. Find each one's beta number and decide whether the risk is worth taking, based on what you know about the company.

This part depends on live beta and S&P data pulled from a financial site, so it's left for you to complete with current numbers rather than filled in here.

Mathematical Strand

Thinking Algebraically: What Does Beta Tell Us?

Calculate the monthly percentage change in each stock and in the S&P 500, using the formula:

% change from month a to b = [(price in month b) − (price in month a)] ÷ (price in month a) × 100%

Example: from November to December for Expedia, (124.30 − 123.11) ÷ 123.11 × 100% = 0.96%.

Company A

Month	Price	% Change	S&P 500	% Change
Nov 2017	$123.11	—	$2,584.84	—
Dec 2017	$124.30	+0.97%	$2,673.60	+3.43%
Jan 2018	$101.04	−18.71%	$2,823.81	+5.62%
Feb 2018	$104.11	+3.04%	$2,713.83	−3.89%
Mar 2018	$107.82	+3.56%	$2,640.87	−2.69%

Company B

Month	Price	% Change	S&P 500	% Change
Nov 2017	$65.96	—	$2,584.84	—
Dec 2017	$62.66	−5.00%	$2,673.60	+3.43%
Jan 2018	$60.89	−2.82%	$2,823.81	+5.62%
Feb 2018	$65.12	+6.95%	$2,713.83	−3.89%
Mar 2018	$72.11	+10.73%	$2,640.87	−2.69%

Company C

Month	Price	% Change	S&P 500	% Change
Nov 2017	$59.36	—	$2,584.84	—
Dec 2017	$59.21	−0.25%	$2,673.60	+3.43%
Jan 2018	$61.80	+4.37%	$2,823.81	+5.62%
Feb 2018	$68.16	+10.29%	$2,713.83	−3.89%
Mar 2018	$71.89	+5.47%	$2,640.87	−2.69%

Company D (matches source key exactly)

Month	Price	% Change	S&P 500	% Change
Nov 2017	$13.04	—	$2,584.84	—
Dec 2017	$12.54	−3.83%	$2,673.60	+3.43%
Jan 2018	$9.12	−27.27%	$2,823.81	+5.62%
Feb 2018	$9.45	+3.62%	$2,713.83	−3.89%
Mar 2018	$10.85	+14.81%	$2,640.87	−2.69%

Q1

Which of the stocks above had percentage changes that were very different from the market?

Using the corrected numbers, the honest answer is: all four companies show months where their percentage change is very different from, and often opposite in direction to, the S&P 500. Company D is the most extreme (a −27.27% January against the market's +5.62%). Company B is notable in a different way: it moved in the opposite direction from the market in all four months, which is a distinct pattern from simply "more dramatic" moves. This differs from the source key's stated answer ("Company A and Company D"), which appears to follow from its incorrect price-change figures for A, B, and C.

Q2

What do you think this means about their beta numbers?

A stock that consistently moves opposite the market (like Company B here) isn't well described by a simple "high beta" label, since beta assumes the stock tends to move in the same direction as the market, just by a larger or smaller amount. A pattern like Company B's suggests either a low or even negative correlation to the market over this period, which real beta calculations do account for, but which four months of data can't reliably distinguish from noise. This is a good moment to revisit the worksheet's own caution: real beta numbers come from sophisticated statistical tools, and a few months of eyeballed data only gives a rough intuition, not a reliable estimate.

Q3

Which of the stocks above have percentage changes that were fairly similar to the changes in the market?

With the corrected numbers, none of the four track the market especially closely; Company A's December (+0.97% vs. the market's +3.43%) and Company C's January (+4.37% vs. +5.62%) are the closest same-direction, similar-magnitude matches, but neither holds up across all four months. This is a real change from the source key's claim that Company B tracks the market well, which was based on its incorrect (and, as shown above, oppositely-signed) figures for Company B.

Q4

What do you think this implies about their beta numbers?

If no company cleanly tracks the market across all four months, it implies that four monthly data points simply aren't enough to pin down a reliable beta for any of these four companies. That's a legitimate and useful lesson in its own right: it mirrors the worksheet's own warning that real beta figures require "sophisticated statistical tools" over a much longer history, not a handful of eyeballed months.

Q5

Predict next to each company whether its beta number would be high or low.

Based on sheer size of swings (not direction), largest to smallest: Company D (a −27.27% single-month move) would predict the highest beta magnitude, followed by Company B (up to about 11%), then Company C (up to about 10%), then Company A (up to about 19% in its worst month, but calmer in the others). Because Company B moved opposite the market every month in this small sample, its true beta could plausibly come out low or even negative rather than high, which is a good discussion point: size of swing and beta are related but not the same thing; direction relative to the market matters too.

Mathematical Strand

Interpreting Statistics: Interpreting Beta Numbers

If you are a financial advisor, you need to understand your clients' tolerance for risk, and use your knowledge of beta numbers to help inform them about how risky an investment is.

In a meeting, your client, who has low risk tolerance, says they don't want to invest in a stock because over a 52-week period, the stock's price changed between a high of $120.47 and a low of $75.42. The client describes this change as "wild" and doesn't want to invest in such a risky stock, but you know that this stock has a beta number of 1.01.

Q1

What is the overall change from the stock's high and low prices?

$120.47 − $75.42 = $45.05.

Q2

As a percentage change, how big is this change in stock price?

$45.05 ÷ $120.47 × 100 = 37.40%. That's a large swing on its own.

Assume the graph in your packet is the Dow Jones Industrial Average over the same period: it climbs to a circled high point, then drops sharply to a triangle-marked low point, before partially recovering.

Q3

How does the chart help explain why the dramatic change occurred, even though the stock has a beta of 1.01?

The Dow itself had a similarly dramatic climb and drop over the same period. A beta of 1.01 means this stock is expected to move almost exactly with the market, so if the whole market swung wildly, a beta-1 stock swinging just as wildly isn't a sign of stock-specific risk; it's just doing what the market did.

Q4

If the circled point on the graph represents a value of $12,783, calculate the value of the triangle point, assuming the percentage change in the Dow matches the 37.40% you calculated in Q2.

$12,783 × (1 − 0.3740) = $12,783 × 0.6260 ≈ $8,002. Checking it the other way: ($12,783 − $8,002) ÷ $12,783 × 100 ≈ 37.4%, which confirms the figure.

Q5

Use your knowledge of beta to explain to your client what may have been going on in the stock market during this time, and why this fluctuation may not be that "wild" after all.

This is open-ended, but a reasonable answer: something unusual likely affected the entire market during this period, not just this one stock, since a beta-1.01 stock only swings this hard if the market itself does. That could be a natural disaster, a major economic shock, or an event that spooked investors broadly. The takeaway for the client: the stock wasn't unusually risky relative to the market; the market itself was unusually volatile that period, and a low-beta stock in that same window would have looked calm by comparison.

Mathematical Strand

Communicating Quantitative Information: Beta and Volatility

The graphs below illustrate how stocks with different beta numbers perform against the market as a whole (the Dow Jones Industrial Average, shown as the solid line in each).

Company A — Beta 1.02

Solid = Dow Jones Industrial Average, dashed = Company A. With beta close to 1, the dashed line tracks the solid line closely.

Company B — Beta 2.3

With beta over 2, Company B's swings are noticeably larger than the market's in the same direction, overshooting every move.

Company C — Beta 5.8

With beta near 6, Company C spikes far above and below the market's line on every move: the highest-risk, highest-volatility pattern of the three.

Q1

Which graph shows a stock whose performance most closely resembles the trend of the Dow Jones Industrial Average?

Company A (beta 1.02), the beta closest to 1.

Q2

Which graph shows a stock whose performance was more dramatic than the Dow's?

Company C (beta 5.8) shows the most dramatic swings, by a wide margin over Company B.

Q3

What's different about the graph of a stock's relative performance when it has a beta close to 1 compared to a beta close to 5?

When a company's beta is close to the market's (close to 1), its line stays close to the Dow's line throughout. When beta is close to 5, the stock's line repeatedly spikes well above and drops well below the Dow's line, amplifying every market move several times over.

Q4

Describe what a stock's relative performance graph would look like compared to the Dow, if the stock had a beta of 3.

This is an open drawing exercise; students can use the graphs above as reference points. A beta of 3 should sit between Company B (2.3) and Company C (5.8): its line should overshoot the Dow's every move by roughly three times the magnitude, more exaggerated than Company B but not as wild as Company C.

Q5

Describe what a stock's relative performance graph would look like compared to the Dow, if the stock had a beta of 8.9.

Also open-ended; students can use the graphs above as examples. A beta of 8.9 is even more extreme than Company C's 5.8, so the line should spike further above and drop further below the Dow's line on every single move, the most volatile pattern of any company in this set.

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Background

Vocabulary

Performance Objectives & Subject Areas

Springboard Activity

Low Risk, High Risk, and the Three Categories

Conservative, Moderate, or Speculative?

To Risk or Not to Risk?

Research Guidelines

Understanding Beta

Thinking Algebraically: What Does Beta Tell Us?

Interpreting Statistics: Interpreting Beta Numbers

Communicating Quantitative Information: Beta and Volatility