How Risky Are Hong Kong Stocks? - Lessons for the Fund Manager
Team Latte
Nov 01, 2002

How risky are Hong Kong stocks? How do you assess the risk of stocks listed on the Hong Kong Stock Exchange? Or, in other words, how much do you stand to lose by investing in HSBC or Cheung Kong Holdings or a portfolio of stocks comprising HSBC, Cheung and other Index constituent stocks?

The commonest measure of risk, as explained in my earlier column, is volatility or historical volatility. It is best defined as the amount of variability in the returns of a particular stock. For the mathematically initiated reader, volatility may be defined as the standard deviation of the return of the particular stock. The more volatile a particular stock is, i.e the more volatile the return from a particular stock is, the more risky is that stock. But how does volatility help us in measuring our potential loss from investing in a particular stock?

Volatility, or more appropriately historical volatility, is measured as the standard deviation of the continuously compounded return of an asset. And continuously compounded return is calculated as the natural logarithm of yesterday's price of the asset divided by today's price. Let's say that using a five year price history we have calculated the annualized volatility of HSBC stock as 37.96%. This means that the annualized standard deviation of the HSBC stock is 37.96% or in plain English the variability or the deviation of HSBC stock from its average expected value, the mean annual return of the stock over the last five years is 37.96%. Thus if, over a five year period, the average annual return for HSBC stock was -0.83% then for the next year a possible return could be (-0.83% + 37.96%) and another possible return could be (-0.83% - 37.96%). This shows that the return will vary from the average value and that variability is the measure of volatility.

If the annualized volatility of the HSBC stock is 37.96% then an investor investing HK$100,000 in that stock stands to lose HK$37,960 in one year. This is calculated by simply multiplying the volatility of 37.96% by the amount invested, i.e. HK$100,000 (HK$100,000 X 37.96% = HK$37,960). In fact to be sure the loss could be much more than this. But this is a possibility and there is a particular probability assigned to it i.e. 33%. In other words, there is a 67% probability that an investor investing HK$100,000 in HSBC stock will not lose more than HK$37,960 in a year if the annualized volatility of HSBC stock is 37.96%.

In fact the probability of loss is calculated via a multiplier. This multiplier signifies the area covered under thenormal distribution of the asset return. (Remember, that financial markets theory assumes that asset returns are log-normally distributed, i.e. the natural logarithm of the asset return is normally distributed). Further, roughly 66.66% of the area under the normal distribution is 1.00 times standard deviation and 95% of the area of the normal distribution is 1.65 times the standard deviation. If the volatility is multiplied by 1 then it is the 66.66% probability of loss. Thus, if the volatility is multiplied by 1.65 then it is the 95% probability of loss and if multiplied by 2.33 then the probability of loss is 99%. Therefore, in the above case the 99% probability of loss would be calculated as (HK$100,000 X 37.96% X 2.65) or equal to HK$100,600. Therefore, we say that that if the annualized volatility of HSBC stock is 37.96% then there is a 99% probability that the investor will not lose more than HK$100,600 in a year's time. He will lose more than his investment of HK$100,000 (this could represent borrowing on his part to invest in the stock). In other words, in the extreme case there is a possibility that the investor will lose his shirt.

Of course the above case of 99% probable loss is an estimate and shows an extreme event. But these events can happen and there is a real possibility of such a loss if the investor holds on to his stock. In all likelihood the investor will move out of this stock if his losses become large but the above calculation demonstrates the threat, possibility and the quantum of loss under each possibility from an investment in HSBC stock. Below is an illustration of investment in HSBC and Cheung Kong Holdings stocks and the probability of experiencing loss.

Table 1.0

Listed below are the volatilities - historical volatilities - of Hang Seng Index and all the 33 constituent stocks that comprise the Hang Seng index. Daily, Monthly and annualized volatilities are given to make the investor appreciate the magnitude of variability and thereby the possibility of an equivalent loss, per day, per month and per year.

Table 2.1

Non-weighted Historical Volatility

5 year Price Data (Jul 1997 - Sep 2002)

The above table shows that most of the constituent stocks exceed the volatility of the Hang Seng index and thereby are more risky than the index itself. An investor is much better off investing in the index, perhaps, through futures or index funds, than investing either in individual stocks or creating a customized portfolio of these stocks.

A big problem with volatility is that it changes from period to period and is not a static concept. Therefore a 37.96% volatility number for HSBC stock may change in a month's time or a quarter's time. It is therefore always better to work with volatility ranges.

Shown below is a chart of historical volatility (annualized) for Hang Seng index for a period of six years (1996 - 2002). It shows that the historical volatility for the index is mostly bounded between 20% and 40%. There are rare spikes above 40% - times of severe turbulence like the Asian financial crisis of 1997-98 and some leak below 20% - times of relative quite.

It must be emphasized though that given this six year period the volatility of the index has remained high. Even a 20% annualized volatility is a high number given the global stock market history of some 75 years.

Fig 1.0

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