How to Measure and Manage Risk of Your Portfolio

Portfolio risk refers to the risk that an investor takes on when they invest in a portfolio of assets. Low-risk portfolios typically have low returns, while high-risk portfolios can provide high returns but also come with a higher degree of risk.

There are a variety of risks that can affect a portfolio, which falls into two main categories: individual security level risks and main portfolio level risks.

Types of Portfolio Risk

  • Individual Security Level Risks

The first category of risks is individual security level risks. These are the risks that are specific to each security in the portfolio. The most common individual security level risks are liquidity risk, default risk, and duration risk.

Liquidity Risk

Liquidity risk is the risk that an investor will not be able to sell their securities when they want to. This can be caused by several factors, such as a lack of buyers in the market or a company going bankrupt.

Default Risk

Default risk is the risk that a company will not be able to repay its debts. This can be caused by factors such as bankruptcy, financial distress, or a natural disaster.

Duration Risk

Duration risk is the risk that the value of a security will change due to changes in interest rates. Securities with longer durations are more sensitive to interest rate changes than securities with shorter durations.

  • Main Portfolio Level Risks

The second category of risks is main portfolio level risks. These are risks that are not specific to any individual security but rather affect the entire portfolio. The most common main portfolio level risks are risk, inflation risk, interest rate risk, and concentration risk.

Market Risk

Market risk is the risk that the value of the portfolio will change due to changes in the market. This can be caused by factors such as a recession, financial crisis, or war.

Inflation Risk

Inflation risk is the risk that the purchasing power of the portfolio will decrease due to inflation. Inflation can be caused by factors such as rising prices or a weak dollar.

Interest Rate Risk

Interest rate risk is the risk that the value of the portfolio will change due to changes in interest rates. When interest rates rise, the value of securities with fixed interest rates will decrease, and when interest rates fall, the value of securities with fixed interest rates will increase.

Concentration Risk

Concentration risk is the risk that the portfolio is too heavily invested in a single security or sector. This can be caused by factors such as market conditions or a company’s financial health.

Knowing Your Risk Tolerance

Before investing in a portfolio, it is important to know your risk tolerance. Your risk tolerance is the amount of risk you are willing to take on in order to achieve a higher return.

An investor can either be risk-averse or risk-tolerant.

Risk-Averse

An investor with a risk aversion is willing to accept less return in order to avoid taking on any risk.

Risk-Tolerant

A risk-tolerant investor is willing to take on more risk in order to receive a higher return.

Measuring the Risk of a Portfolio

When investing, it is important for an investor to measure the risks involved. There are several ways investors can do this, including by beta and Sharpe ratio.

Beta

Beta measures how much the price of one stock changes relative to the market’s movements. Beta values can either be equal to 1, less than 1, greater than 1, or negative beta.

A beta value equal to 1 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 1 means that the stock tends to trade very little in relation to general share-price movements. Thus, the stock, in this case, is theoretically less volatile than the market.

A beta value greater than 1 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 actually rise in value when the market is falling.

Sharpe Ratio

The Sharpe ratio measures how much return an investor can expect per unit of risk.

It is calculated by taking the average return earned over a period of time and subtracting the risk-free rate from it. The resulting number is then divided by the standard deviation of the returns for that same period of time.

The higher a portfolio’s Sharpe ratio, the better it performs relative to its level of risk.

Sharpe_Ratio_Formula

Managing the Risk of a Portfolio

There are several things an investor can do to manage the risk of their portfolio including diversifying and hedging.

Diversifying

Diversification is the practice of investing in securities that are not highly correlated to one another. This reduces exposure to risk because there is less chance that all assets will depreciate simultaneously.

Hedging

Hedging is taking both a bullish and bearish position on an asset at the same time to reduce exposure to loss.

For example, if an airline wanted to protect itself from rising oil prices it could hedge by purchasing oil futures at $65/barrel as well as buying put options for $33/barrel. If oil prices fell below $65/barrel, the company would buy oil futures at $65/barrel so they could sell them at the higher price, and if oil prices rose above $33/barrel, the company would sell their put options.

The Bottom Line

Portfolio risk is a measure of the uncertainty of returns an investor can expect from an investment in a portfolio.

Several types of risks can affect a portfolio, including market risk, inflation risk, interest rate risk, liquidity risk, and default risk. Investors should be aware of their risk tolerance before investing and measure the risks of their portfolio using beta and the Sharpe ratio.

Investors can manage the risk of their portfolios by diversifying and hedging.

Both approaches, diversification and hedging, have the same impact – they reduce portfolio risk. However, diversifying is a less expensive way to achieve the same results as hedging.
Beta can be a better indicator of risk because it gives investors information about how much volatility they should expect from an investment relative to other investments in the market. The Sharpe ratio also tells investors about their performance against another investment but does not take into account the volatility involved.
No, hedging is not always effective because it relies on correctly predicting future movements in the market. If an investor is wrong about which direction the market will move, they could lose money on their hedge position.
Beta values do not fully take into account all variables that may affect volatility.
Knowing your risk tolerance helps investors match investment choices to their level of risk so they can make more prudent decisions about which investments are best for them. Not knowing your risk tolerance could lead you to invest in far too risky or conservative portfolios, which will likely result in underperformance relative to what you might otherwise be able to achieve by finding the appropriate balance between returns and risk.

Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.