Portfolio Risk Management: How to Measure and Manage Portfolio Risk
Investing your money involves a number of strategies and instruments. This is why it always contains an element of risk. Each tool can deliver different returns. The ideal investment term for each instrument also differs. Some may provide earnings in the short term and others in the long term. So, the decision to pick an option can depend on the investment term and whether or not it aligns with your financial goals. In addition to this, every investor has a risk appetite. It may be high when you are young and have a steady income. This way, you can absorb the short-term market fluctuations and eventually exit with high returns. However, if you are nearing retirement, your risk appetite would ideally drop. With little time on your hands, relatively low-risk options like bonds may be more suitable at this juncture of life.
There are several types of risk that can impact your returns. Interest rate risk, inflation risk, recession risk, and others can surface from time to time and affect your investments as well as peace of mind. This is why portfolio risk management can be very critical. It can help you lower the chances of loss and maximize the scope of gains. However, it is crucial to understand how to manage portfolio risk and what can trigger it. If you wish to learn about different kinds of risks that can affect your investments and how you can mitigate them, consult with a professional financial advisor who can guide you on the same. Keep reading to find out more.
What is portfolio risk?
Typically, risk refers to any threat or an unlikely event that can lead to failure. In the case of an investment portfolio, risk refers to the likelihood of your combination of assets and investments not meeting your financial goals. The portfolio is made up of different asset classes, investments, market capitalizations, etc. The higher the risk associated with each of your investments, the higher would be your overall portfolio risk and vice versa. For instance, if you have a higher allocation in equity, your portfolio would carry more risk than if you had more investments in debt. Risk is not always a bad thing. In fact, it can be good for your portfolio. Risk can be directly related to returns in many cases. So, if you put your money in high-risk-return instruments, you may stand to benefit in the long run. Similarly, a low-risk portfolio may not always be the best thing, as the returns associated with low risk are also low.
Having said that, it is essential to identify your risk appetite and the risks accompanying your investment choices. This way, you can manage it the correct way without stressing over market fluctuations.
What are the risk factors involved in a managed portfolio?
A managed portfolio can have several risk factors. Some risk factors of a managed portfolio have been discussed below:
1. Asset class risk:
As explained above, every asset class has a certain amount of risk attached to it. Typically, you can categorize asset classes into three types – equity, debt, and cash. Equity can be susceptible to market risk. For instance, stocks are volatile as they can be affected by several factors like demand and supply, corporate decisions, investor sentiment, etc. The stock prices of the company Coca-Cola took a massive hit just because the ace footballer Christiano Ronaldo chose water over it. An event as unimportant as this put the company through massive loss and ultimately impacted the shareholders.
2. Inflation risk:
Inflation risk is another one of the many risk factors of a managed portfolio, which refers to earning returns below the rate of inflation. For instance, if your investment generates a 5% rate of return, but the inflation rate rises to 7%, you would ideally lose money. This can be seen evidently today. The inflation rate in the U.S crossed 8% in March 2022. So, if the value of your investment returns in relation to inflation has been lowered, you would suffer as your money would lose weight in the long term. This is why it is recommended to invest in inflation-beating instruments. Debt and cash are usually low-faring with regard to inflation. However, equity may deliver inflation-beating returns over a long investment term.
3. Liquidity risk:
Liquidity risk refers to not being able to get a fair market price for your investments if you sell them in the short term. In simple words, it can also mean not being able to liquidate your assets if you have an urgent financial need. For instance, cash has the highest liquidity. You can withdraw your money from the bank anytime you want without incurring any penalties or taxes. However, liquidating your 401k retirement account can be cumbersome. Withdrawals before the age of 59.5 can trigger a 10% penalty. Likewise, if you own real estate, you may find it hard to sell it off instantly if you need immediate funds.
4. Credit risk:
Credit risk is associated with debt securities like bonds. The possibility that the bond issuing entity, such as the government, municipality, or company, may run into a loss and will be unable to pay you interest is known as the credit risk. This is why bonds have credit ratings that help you understand the credit risk associated with them.
5. Longevity risk:
Longevity risk refers to running out of your money in your lifetime. Retirement investment portfolios that may not be enough to last you a lifetime have a high longevity risk, as the chances of being left without money in the later years of retirement are high.
How to measure portfolio risk
Here are some parameters that can help you measure the risk in your portfolio and subsequently help in portfolio risk management:
Beta refers to the fluctuations of a stock with respect to the changes in the overall stock market. The S&P 500 Index has a beta of 1.0. If your stocks have a beta above 1.0, it means they are moving above the market and pose a higher risk. However, if they move below the market, the stock would have a beta of less than 1.0 and would pose a lower risk. Their returns would be directly proportional to the risk.
2. Sharpe ratio:
Named after the Nobel laureate William F. Sharpe, the Sharpe ratio is used to measure the risk-adjusted returns of an investment. Similar to the beta, a higher Sharpe ratio indicates higher risk and return, and a lower Sharpe ratio indicates lower risk and returns. The Sharpe ratio can be calculated using the following formula:
Sharpe Ratio = Rp − Rf/ σp
- Rp is the return of the portfolio
- Rf is the risk-free rate
- σp is the standard deviation of the investment portfolio’s excess return
3. Value at Risk (VaR):
VaR measures the scope of financial loss of an investment portfolio for a given period. It can be increased when you add or remove investments from your portfolio.
How to manage portfolio risk
Here are some portfolio risk management strategies that can help lower over risk:
1. Diversify your investment portfolio:
Diversification is one of the best investment strategies you can adopt to lower risk. Since no two asset classes or market caps would ideally react the same way to market fluctuations, you can reduce the risk by adding multiple investment options to your portfolio. For instance, when investing in mutual funds, it is often advised to add large, mid, and small-cap funds to your portfolio. Large caps are the most stable, followed by mid and small caps. So, by keeping a mix of investments, you can depend on the more stable ones for minimizing risk and the more volatile ones for maximizing returns. Diversification can be across asset classes, such as equity, debt, cash, real estate, commodities, etc. It can also be across industries and sectors, like pharmaceuticals, technology, tourism, etc. You can diversify across markets by adding domestic and international stocks, too.
2. Rebalance your portfolio regularly:
Everyone has a unique risk appetite according to which they create a portfolio. However, your asset allocation can fluctuate over time, depending on how your investments fare. For instance, consider a scenario where your original asset allocation was 60% in stocks and 30% in debt, and 10% in cash. However, if your stock investments do well than others, your asset allocation may change over time. In such a case, your risk will also increase. Now, if your risk appetite does not rise, you will expose yourself to higher stakes than you are ready to take on. Therefore, in such a case, you can benefit from rebalancing your portfolio. This can be done by exiting from equity and investing that money in debt or cash to bring your asset allocation back to its original composition.
3. Maintain liquidity:
Liquidity is an important concept. A lot of investors concentrate their money on long-term investments with a view to benefiting in the future. However, any unexpected event in the short term can occur and catch you off guard. For instance, if you invest in a 401k, you would not have liquid money to cater to a financial emergency, such as a job loss. Likewise, if you have no liquid cash and the stock market crashes, you would not have any money to buy stocks at a discounted price and benefit later when the market rises. Therefore, maintaining liquidity is very critical to managing risk.
4. Maintain safety of margin:
The safety of margin refers to the difference between the intrinsic value and the price of your investment. The higher the safety of the margin, the lower the risk as your profit margin is increased. However, it is essential to be careful while maintaining the safety of the margin. You may think the best way to pick a high safety of margin is by buying stocks at a discounted price. However, this is not enough. There are several other aspects along with the price of a stock that can play a role in your returns. So, it is highly advised to look at the company’s fundamentals, core principles, financials, management, past performance, market capitalization, etc., and then take a call.
5. Be rational and avoid emotional investing:
Emotions in investing can be a lethal combination. Therefore, try to be as rational and logical as you can when selecting investments. Do not depend on your friends, trends, or fads to invest your money. Instead, look at numbers, historical data, and factual information to make a decision. Likewise, selling or exiting investment schemes can also be done based on statistics and not panic or stress. A lot of people leave the market in a state of panic when the market starts to fall. However, this can be an excellent time to buy the dip and eventually earn a profit when stock prices start to recover.
6. Pick investments according to your financial goals:
Another way to lower the risk factors of managed portfolio is to pick investments according to your goals. Long-term goals like retirement require a long-term approach. So, if you invest in a 401k and are not able to withdraw your money before the age of 59.5, this can be a blessing in disguise as it ensures your money gets the time it needs to compound and offer you a financially secure retirement. However, you can balance this out by including short-term or more liquid investments like stocks, bonds, mutual funds, etc., to lower liquidity risk.
Understanding and knowing how to manage portfolio risk is essential at every step of your financial journey. Unnecessary risk can lead to losses and delays. And if you have a short investment horizon, unwanted risk can doom your economic growth for good. Therefore, making sure you use strategies to evade it can be critical. Risk management also makes investing fun and keeps the stress away.
However, if you find it challenging to manage risk, you can hire a financial advisor and get help with stock investments, retirement planning, and more. Use WiserAdvisor’s free advisor match service to find highly qualified and vetted wealth advisors who can guide you on the same. Answer a few questions about yourself and get matched with 1-3 wealth advisors that are suited to meet your financial requirements.