Standalone Risk: Meaning
We can define “standalone risk” as the risk that an investor faces when he holds only one single asset as an investment. And this single asset holding or investment could be by any individual or a business organization. The asset in question can be in the form of a stock, sole department, or operations division of an organization. It can be any other similar asset of commercial value. Standalone risk arises when we go against the policy of diversification of portfolios. We just concentrate our resources on a single asset. We calculate this risk by making the assumption that all of the losses and gains will come from that one particular asset to an investor.
Hence, the key to mitigating such risks is the diversification of our portfolio. We should spread our investment between multiple assets or departments. This will minimize the unsystematic risks. Also, it will take care of risks that are specific to a particular company or asset.
There is an age-old proverb in the financial world that “Do not put all your eggs in one basket.” This approach insists on a well-diversified holding of assets or investments by the investor/business organization/portfolio managers, etc. In the financial world, many times investors treat their big investments or large divisions of a business as a separate entity. We then calculate the standalone risk of that individual entity. Investors can determine the extent of risk to expect from that asset, in comparison to the expected return from that asset.
How do we Measure Standalone Risk?
We use a number of statistical techniques to assess the standalone risk of an asset. Let us have a look at them in detail.
Beta measures the volatility of an asset or an investment in comparison to the overall market. Specialists use beta to measure the standalone risk of an asset in comparison to the risk of a well-diversified portfolio of multiple assets. It helps an investor to understand how volatile and risky the standalone asset is. Also, it helps him choose between the two options of investing. He can either invest in a standalone asset. Or go for a mix of assets in the form of a diversified portfolio. Again this depends upon his risk appetite, market trend perception and so on. Aggressive investors prefer to go with the investments having a beta value of more than 1 whereas conservative or moderate investors would like to go with the assets having a beta lesser than 1.
Coefficient of Variation
The coefficient of variation is a statistical measure that investors use. It helps to find out the extent of variation of the expected returns from a standalone asset from the mean or average expected returns of a diverse and balanced portfolio. In case the coefficient of variation is low, an investor can expect to earn a high return with low risk.
On the other hand, if the coefficient of variation is high, an investor can expect to earn a lower return at a much higher risk. Thus, in this case, he can avoid investing in that particular standalone asset.
Sensitivity analysis is an effective way to adjudge the standalone risk of an asset. It takes into consideration multiple variables that can have an impact on the risk and returns of that asset. Analysts can create a “what-if” situation or a simulation. On this basis, they can evaluate the risks associated with a particular asset. They can evaluate the factors that can result in the change in price or returns of that asset. Investors can take an informed decision on the basis of a fair evaluation of the standalone risk of their investment considering the impact of key factors.
Investors can also make use of the Hillier model to assess the standalone risk of a particular asset or investment. In this model, we calculate the standard deviation of the cash flows that we expect from the investment. We then compare it with the standard deviation of the cash flows that we expect from a diverse and balanced portfolio.
A high standard deviation of the cash flows from an investment will mean that the investor will have to bear a high level of risk and vice-versa.
Summary: Standalone Risk
There are many instances when an investor is inclined to invest his or her entire investable surplus in one particular stock. He may also make a considerable investment in some particular asset that has a financial value. This may be due to expectations of excessive returns from the investment. He may invest for some other benefit such as enhanced safety. Or not finding any other such investment opportunity. Investors have to be very cautious in such cases as they will have to face standalone risk with their investment. In case the company performs well, the return from the investment may match the expectations of the investor. It may even exceed his expectations in some instances. However, if the company’s performance is not on the expected lines then the investor may lose a substantial portion of his investment. The same is true with investment in any other asset class.
Advantages of a Standalone Unit
In the case of companies, individual entities or departments may sometimes prove beneficial rather than being part of a group. In the case of a company that operates as a single structure, lenders and creditors can approach the main office and demand their money back, even if the default is caused by the negligence of one small branch. On the other hand, lenders’ and creditors’ claim is limited only to the assets of a particular department or branch in case a company operates through separate smaller legal entities. Thus, in such cases, the company will actually benefit from such an arrangement.
Investors should thoroughly assess the standalone risk of their investment. They can measure its beta, coefficient of variation, or use other measures as mentioned above. They may also minimize this risk by efficient diversification of their portfolio. Investors can include different kinds of stocks or assets and create a balanced portfolio. This will help them to mitigate the effect of standalone risk. They will be able to make profits even if a particular asset or stock underperforms or fails. The only caution here is that diversification should not be only for the namesake i.e. investments in similar kinds of assets. Or there should not be too much of a diversification.
Frequently Asked Questions (FAQs)
It is the risk that an investor faces when he holds only one single asset as an investment. The asset can be in the form of a stock, sole department, or operations division of an organization.
Standalone risk arises when we go against the policy of diversification of portfolios.
Some statistical techniques to assess the standalone risk of an asset are:
2. Coefficient of variation
3. Sensitivity analysis
4. Hillier analysis