A stock's expected return only projects the most likely outcome for an investment, and doesn't calculate risk factors. If potential returns differ greatly from the expected return, it's a riskier investment. Using the statistical measure of variance, investors can determine a risk factor for each stock that indicates its potential to swing widely from expected returns. This measure may then be used to analyze the risks and potential outcomes of two stocks with similar expected returns.
Calculate the difference (D) between the expected return (R) and each potential possible return, variable (r1, r2) for each possible return. Use the formula: Dn = R -- rn, or D1 = R -- r1, D2 = R -- r2, etc. You'll raise D to the second power in a future step, so don't worry if D values are negative, as you'll deal in absolute value.
Square each D value you calculated in the previous step. Multiply those figures by the probability, variable Pn, of that return as reported in the expected return probability table. This figure is variable Gn: Gn = Pn(Dn^2), or G1 = P1(D1^2), G2 = P2(D2 ^ 2), etc.
Total all G values to arrive at V1, the variance of the first stock: V1 = G1 + G2 + G3 ... Gn
Repeat Steps 1 through 3 for the second stock. A higher variance represents a wider range of possible outcomes, which represents a riskier investment.
Items you will need
- Expected return projection for each stock
- Expected return probability tables for each stock