Portfolio risk is the potential for the value of your investments to fluctuate, with chances of a decline or variance in returns. Managing investment portfolios is a crucial aspect of financial planning, yet it comes with inherent risks that investors must navigate. This article will delve into the concept of portfolio risk, exploring its various types such as market risk, credit risk, and liquidity risk. We will also discuss the best strategies for managing these risks, including diversification, asset allocation, and the use of financial instruments like options and futures. By understanding and effectively managing portfolio risk, investors can safeguard their investments and enhance long-term returns.
What is portfolio risk?
Portfolio risk refers to the chance of your portfolio value decreasing, leading to lesser returns or losses. At times, losses accumulating due to portfolio risk factors can even affect your financial goals. All investments carry some form and degree of potential risks, whether while trading in the stock market, investing in mutual funds, or trading in the forex market. The inherent risk in market investments is why every smart investor knows how to efficiently balance the risks and rewards.
What is the best way to manage portfolio risk?
Every investment portfolio carries risks. The best way to manage portfolio risk is to avoid putting all your money in one instrument. Instead, diversify your investments across assets like bonds, cash, and stocks to minimise risk.
Risk factors are numerous and diverse. However, an understanding of the potential sources of market vulnerability is important as it can help you plan your strategies effectively and ultimately manage your portfolio better.
Also read: What Is Compound Annual Growth Rate (CAGR)
Types of portfolio risk
Following are some of the major factors that can potentially affect your investment returns:
1. Market risk
Market risk includes factors that affect the entire financial market, including the stock market. This includes changes in interest rates, macroeconomic conditions, inflation, recession, and natural disasters. It is also called systemic risk. What’s interesting to note here is that market risk cannot be mitigated by portfolio diversification—the most popular risk mitigation strategy, as it affects the entire financial system.
2. Liquidity risk
Not all investment instruments are equally liquid. While some provide a high degree of liquidity, like mutual fund schemes, others, like real estate or private equity, may be tougher to liquidate and avoid losses if the market moves unfavourably. Liquidity risk may lead to losses as it may necessitate selling off assets at a lower-than-expected price. A good way to mitigate this risk is to have part of your investment portfolio dedicated to liquid assets. For example, you can easily compare mutual funds and invest in a scheme that best aligns with your goals.
3. Credit risk
Credit risk is the chance of incurring a loss as the issuer of the bonds or other financial instruments in your portfolio fails to meet their payment obligations. This includes failure to repay loans and is more commonly associated with corporate bonds. In such cases, a company's trustworthiness becomes a big factor in choosing the right bonds to invest in.
4. Inflation risk
Inflationary risk poses a threat to investment returns by eroding purchasing power. Bond investments are particularly vulnerable to this risk due to their fixed interest rate payments. As inflation rises, the real value of these fixed payments diminishes.
5. Reinvestment risk
Reinvestment risk arises when an investor cannot reinvest cash flows (e.g., coupon payments, interest) at a rate equivalent to the original investment's yield. This new rate is termed the reinvestment rate.
6. Currency risk
Investors who hold investments in foreign currencies are vulnerable to risks arising from movements in currency exchange rates. A change in the price of one currency (appreciation or depreciation) may pose a portfolio risk depending on the type of investment.
7. Concentration risk
This type of risk arises with homogeneous or similar investments and can be managed effectively through portfolio diversification.
8. Political risk
Political risk refers to the potential for financial loss or reduced returns on investments due to political decisions, events, or conditions within a specific country or emerging market.
How to calculate portfolio at risk?
After learning the various types of portfolio risks, let us understand how to calculate portfolio risk using the methods described below.
1. Standard Deviation
Taking a mean value of returns in your portfolio, we can calculate the standard deviation to understand how returns would be dispersed. The formula for standard deviation is-
2. Value at Risk (VaR)
Value at risk is a statistical technique that can be used to measure the potential financial losses in your portfolio over a given period. It is calculated by factoring in your portfolio's standard deviation, the rate of return, the individual rates of return, and the proportion of each investment in the portfolio.
3. Conditional Value at Risk (CVaR)
This method calculates the expected losses in your portfolio exceeding a specified threshold. It can be viewed as an extension of VaR by representing the anticipated shortfall beyond this limit.
4. Sharpe Ratio
Sharpe Ratio is a popular method for understanding ROI in relation to the associated risk. Its formula is:
5. Sortino Ratio
The Sortino ratio is a risk-adjusted performance measure that focuses on downside risk. Unlike the Sharpe ratio, which considers total volatility, the Sortino ratio isolates downside deviation, or the standard deviation of negative returns. This metric calculates the risk-adjusted return by dividing the excess return over the risk-free rate by the downside deviation. The ratio is named after its creator, Frank A. Sortino.
6. Strategies to manage portfolio risk
Portfolio risk management can help you identify potential risks and vulnerabilities in your portfolio that impact your financial goals. Let us take a look at its major aspects.
7. Identification
This includes identification, documentation, and understanding of potential risk factors.
8. Assessment and measurement
This aspect includes assessing the potential impact of risk factors and relying on quantitative analysis to measure their likely impact on your portfolio.
9. Mitigation and strategy
In this stage, investors devise strategies to mitigate risks, which include budgeting, diversification, and hedging.
10. Monitor and review
Risk management is not a one-time practice but requires constant monitoring and review of the market conditions and risk factors.
Portfolio risk management strategies
By implementing these prudent strategies, investors can mitigate potential losses and construct a portfolio that aligns with their investment objectives and risk tolerance.
Diversification
Diversification involves spreading investments across a variety of assets to reduce overall portfolio risk. This strategy leverages the principle that not all assets will underperform simultaneously, enabling potential losses in one asset to be offset by gains in another.
Asset allocation
Asset allocation entails dividing a portfolio among diverse asset classes, such as stocks, bonds, and cash. The primary objective of this strategy is to construct a portfolio that harmonizes with the investor's risk tolerance and investment aspirations.
Hedging
Hedging involves employing financial instruments, such as options or futures contracts, to counterbalance portfolio risk. For instance, an investor apprehensive about a potential decline in a specific stock's value can acquire a put option to safeguard against losses.
Portfolio optimization
Portfolio optimisation is a strategic approach that involves selecting the optimal combination of assets to maximize expected returns while minimising risk. This strategy utilizes mathematical models to analyse various investment scenarios and identify the most suitable portfolio.
Active management
Active management is an investment strategy that entails making investment decisions based on prevailing market conditions and individual security analysis. This approach is commonly employed by professional investors who possess the necessary time and resources to meticulously analyse securities and make informed investment choices.
Passive management
Passive management is an investment strategy that involves investing in a portfolio that tracks a market index, such as the S&P 500. This strategy is favoured by investors who prefer a low-cost, low-maintenance approach to investing.
Risk budgeting
Risk budgeting is a strategic approach that involves allocating risk across various investment strategies or asset classes. The primary objective of risk budgeting is to construct a portfolio that aligns with the investor's risk tolerance and investment aspirations.
Tools to assess and manage risk in portfolio
The most common techniques for risk management include:
1. Hedging to limit exposure
Using financial instruments to offset potential losses by taking opposite positions in related assets.
2. Active management based on market conditions
Continuously adjusting the portfolio in response to market changes to capitalise on trends and reduce volatility risks.
3. Risk budgeting to align with your risk tolerance
Allocating specific portions of the portfolio to different risk levels to match your risk tolerance and goals.
Portfolio risk and investment goals
Several factors significantly influence investment decisions, including risk-return trade-offs, risk tolerance, investment horizon, and portfolio performance evaluation.
- Risk-return trade-off: Investors must carefully consider the relationship between risk and return. Higher potential returns often correlate with higher levels of risk.
- Risk tolerance: An individual's risk tolerance, which varies based on financial circumstances, investment goals, and personal preferences, determines the level of risk they are willing to assume.
- Investment horizon: The intended holding period of an investment, or investment horizon, impacts the appropriate level of risk. Longer-term investors may tolerate greater risk, while short-term investors often prioritise capital preservation.
- Portfolio performance evaluation: Regular assessment of portfolio performance is crucial. This involves evaluating returns, risk metrics, and alignment with established investment objectives. Such analysis helps investors make informed decisions to optimise their portfolios.
By carefully considering these factors, investors can make informed decisions that align with their financial goals and risk tolerance.
Summary
Portfolio risk refers to potential value fluctuations, leading to reduced returns or losses. Primary types of portfolio risk include market, liquidity, credit, inflation, reinvestment, currency, concentration, and political risks. It can be calculated using methods like standard deviation, VaR, CVaR, Sharpe Ratio, and Sortino Ratio. Effective risk management requires identifying, assessing, mitigating, and monitoring risks through techniques like hedging, active management, and risk budgeting, helping investors navigate uncertainties and protect their portfolios.
If you wish to invest in mutual funds, you can head to the Bajaj Finserv Mutual Fund Platform and select from over 1,000 mutual fund schemes. You can also rely on the lumpsum calculator and SIP calculator to calculate potential returns and choose MF schemes that align with your investment goals.
