What Is Portfolio Risk?
Portfolio risk is the chance that an investment portfolio will lose money because of market volatility, poor judgment or mismanagement, fraud, and other external events.
Importance of Knowing Portfolio Risks
Portfolio risk is a major factor in how much your investments return over time. Portfolio risk is not specific to any one type of investment but can impact any available asset.
Portfolio risk is different from the risks associated with a specific security or industry.
The Different Types of Portfolio Risk
There are several portfolio risks an investor should take into account.
Systematic Portfolio Risk
This type of risk comes from macroeconomic factors like inflation and changing economic conditions that affect all the securities in your portfolio and are out of your control.
Portfolio managers may try to diversify assets to minimize this risk, but there is no way to eliminate it.
Unsystematic Portfolio Risk
Unsystematic risks, also called specific risks, are uncertainties of an investment within a particular firm or industry. Portfolio managers can help avoid and control them because internal factors cause these risks.
Portfolio risk is usually associated with equity portfolios, but investors in any security need to consider their level of portfolio risk.
Loss of Principal Risks
A principal risk is that any of your investments might decrease in value and fail to generate a return greater than inflation, and this could happen regardless of the type of investment you have chosen.
Principal risks are present in almost all investment vehicles except for savings accounts, interest-bearing checking, or a certificate of deposit.
Sovereign Risks
Some governments may print large sums of money to delay or avert a financial crisis, which will devalue their currency. Portfolio managers can reduce the risk by investing in different currencies.
Market Portfolio Risk
The market portfolio is a hypothetical investment bundle containing every tradable security available on the market. Managers expect the return of a market portfolio to match the market’s return as a whole. Since they are entirely diversified, market portfolios are only subject to systematic risk.
Portfolio managers may also create a benchmark index to help manage the investment’s overall performance.
Purchasing Power or Inflation Risks
Purchasing power risk represents a loss of value due to inflation, which negatively affects your bottom line. Portfolio managers can reduce this risk by including fixed-income securities because inflation does not impact their returns.
Calculating Portfolio Risks
Portfolio risk can be measured through various metrics, including beta, standard deviation, and maximum drawdown.
Beta
Beta is a measure of how volatile a particular investment is compared to the market as a whole. Portfolio managers may use a benchmark index to calculate beta.
A beta value equal to one means that the stock's price will move with the market, so it is neither more volatile nor less volatile than that of the market.
A beta value less than one means that the stock tends to trade very little in relation to general share-price movements. Thus, the stock is theoretically less volatile than the market in this case.
A beta value greater than one means that the stock is more volatile than the overall market and can easily be affected by share-price changes in the market.
A negative beta value means that the stock tends to rise in value when the market falls.
Standard Deviation
Standard deviation is another measurement of risk, and it measures the investment risks and the consistency of an investment’s earnings to help determine the stability of a portfolio.
Portfolio managers use standard deviation to estimate how much a portfolio might move in relation to the market over time (a higher standard deviation means a broader range of returns).
Maximum Drawdown
Maximum drawdowns measure how much an investment plunges in value during down markets and then recovers when things turn back around; it compares peaks and troughs. Drawdown measurements track the historical risk of investments, compare fund performance, or monitor trading performance.
Managing Portfolio Risks
Managing portfolio risks begins with recognizing the level of risk appropriate for your portfolio. Portfolios with more money to invest can handle a higher degree of risk, while those closer to retirement may want a lower level of risk.
Your mix of investments also depends on your age and financial goals. After you have decided what mix is appropriate for you, there are several ways that a portfolio manager can reduce the risk of your investments.
Diversifying Investments
Diversifying investments means buying assets across various financial categories. Portfolio managers hope to get the most out of returns by investing in areas that react differently to the same event.
Using Passive Management Strategies
Some portfolio managers will take a passive approach by indexing, which attempts to match the returns of certain market indexes. Indexing offers diversification and lower fees.
The most successful passive investors ignore short-term setbacks and invest in the long haul. Consequently, they do not react to the market’s daily changes .
Using Different Types of Securities in Their Portfolios
Portfolio managers may employ short-term securities, which tend to be less volatile than long-term investments. They will also consider the type of security when managing portfolios.
For example, portfolio managers can construct bond ladders by purchasing bonds in equal amounts every year. They might also buy call options or futures contracts, reducing the risk on equities.
Anticipating Economic Events
Portfolio managers will watch for upcoming economic news that might affect the markets. They may forecast inflation, commodity prices, interest rates, and trade restrictions to see how it impacts different investments.
Many portfolio managers use models based on historical data to look at what kinds of events have occurred in previous years to predict how they might affect different investments.
Portfolio managers with a quantitative background may use computer models to look for patterns in historical data and make forecasts based on those patterns.
Choosing a Portfolio Manager
Experience level is an important factor when selecting a portfolio manager because portfolios with a higher degree of risk may want managers who have more experience and are willing to take on riskier investments.
Portfolios with less capital to invest in will benefit from portfolio managers willing to diversify their portfolios into different asset classes or securities that will minimize risks.
Conclusion
Portfolio risk is the chance of an investment to lose money over time. Portfolio risk levels depend on many factors, including your personal preferences, your financial goals, and your tolerance for volatility.
Risk is an inevitable part of investing. Portfolio managers help manage this risk by diversifying investments, minimizing portfolio risks through passive management techniques, and anticipating economic events that might affect investments.
Portfolios with more money to invest can handle a higher degree of risk, while those closer to retirement may want a lower level of risk. Portfolio managers may also pursue alternative active management strategies such as tax-loss harvesting and dynamic asset allocation.
To reduce portfolio risk, investors can employ portfolio managers with a high level of expertise, diversify their portfolios, or use computer models that examine historical data for patterns that might affect future portfolio performance.
Before deciding on investing, it is wise to consult an expert to help avoid uncalculated risk and grow your money effectively.
FAQs
1. What is portfolio risk?
Portfolio risk is the chance of an investment losing money over time.
2. How do portfolio managers help with portfolio risks?
Portfolio managers help manage portfolio risks by diversifying investments, minimizing portfolio risks through passive management techniques, and anticipating economic events that might affect portfolios.
3. Why is it important to know your portfolio risk?
Knowing portfolio risk will help managers ensure the portfolio stays on track with the investor’s financial plan.
4. How do portfolio risks impact portfolios?
Portfolio risks can impact portfolios in various ways, including affecting investment value, investment duration, and reducing portfolio growth.
5. Which portfolios might benefit from higher portfolio risk?
A riskier portfolio may be advantageous to a long-term investor because there will be more time available to recoup any losses. Additionally, wealthy portfolios can afford to take on more risk because they will be less affected by a decline.
