Portfolio Risk – How to measure and manage the risk of your investment portfolio

Common ways to define your personal risk tolerance and manage risks of investment portfolios

Investors all face a trade-off between risk and return. Investors are rewarded with returns for taking on risk – but that risk must be managed. For any portfolio, the appropriate level of risk must first be determined. And then the portfolio risk needs to be calculated to make sure it lies within that level of risk.

Portfolio Risk
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Knowing and managing investment portfolio risk is the most important factor in growing and preserving capital. In this post we discuss the ways in which portfolio risk can be calculated and managed.

What is investment portfolio risk?

Portfolio risk reflects the overall risk for a portfolio of investments. It is the combined risk of each individual investment within a portfolio. The different components of a portfolio and their weightings contribute to the extent to which the portfolio is exposed to various risks.

The major risks a portfolio will face are market and other systemic risks. These risks need to be managed to ensure a portfolio meets its objectives. You can only manage this risk if you can first quantify it.

Determining your risk tolerance

Risk Tolerance
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In the US market the worst year for bonds was 1969 when bonds returned -5%. The US equity market, as per the DJIA index, has fallen more than 30% on 5 occasions, the worst being 51% in 1931. If both markets were to experience equivalent crashes in the same year, then;

  • An 80% equity / 20% bond portfolio would lose 41.8%
  • An 20% equity / 80% bond portfolio would lose 14.2%

Both portfolios would eventually recover, but this would take far longer for the first portfolio. A portfolio needs to be constructed with this in mind.

Before constructing a portfolio, you need to work out how much you can afford to lose, both financially and psychologically. This is your risk tolerance. Losing too much money late in your career may mean your portfolio will never recover. Losing more money than you are comfortable with can result in stress and irrational decision making. You should never be in a situation where you can lose enough capital to cause you to make irrational decisions.

Financial Advisor / Risk Tolerance
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To properly determine your risk tolerance, you should speak to a financial advisor. You can also use one of the tools wealth managers often include on their websites. You can however get an idea of your risk tolerance by considering your portfolio value, time horizon, monthly income, monthly expenses and the reliability of your income. You should also consider your temperament and how much you are psychologically prepared to lose.

Risk tolerance can be rated as high, moderate or low. If you are at least 20 years off retirement age, have a reliable income stream and some cash savings, your risk tolerance will be high. In the case of a market crash you will have time for the market to recover and you won’t need to draw from your portfolio. On the other hand, if you are approaching retirement age or may lose your source of income, your risk tolerance will be low. Losing money on your portfolio close to, or during retirement, will result in drawing capital from an impaired portfolio.

Risk tolerance is closely related to risk appetite and risk capacity. Your risk tolerance will change only gradually over time. At any given time, it will dictate your risk capacity. Risk capacity can also be thought of as the amount of risk that must be taken to achieve investment goals. Risk appetite considers both tolerance and capacity, and the investment landscape at any given time.

Types of portfolio risks

Portfolio Risks
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There are lots of types of investment risks, both at the portfolio level and the individual security level. Firstly, the following are examples of risks that are specific to individual securities. These risks can easily be managed through diversification:

  • Liquidity risk
  • Default risk
  • Regulatory risk and political risk
  • Duration risk
  • Style risk

Broader portfolio risks can affect the entire portfolio. Managing these risks requires more creative diversification and other strategies. The following are the main portfolio level risks.

The greatest risk facing any portfolio is market risk. This is also known as systematic risk. Most assets correlate to some extent. The result is that a stock market crash will result in most stocks falling. In fact, most financial assets will lose value during a bear market.

At the other end of the risk spectrum is inflation risk. This is the risk that a portfolio’s buying power will not keep up with inflation. Thus, the reason a portfolio needs to include “risky assets” and risk needs to be managed. Over the long term, owning risky assets allows you to outperform inflation.

Investment / Making Money
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Reinvestment risk can affect the entire bond portion of a portfolio. If bonds are purchased when yields are high, the holder earns those high yields even if interest rates fall. However, if yields are low when the bond matures, the principal cannot be reinvested at a high yield.

Concentration risk concerns the correlation of assets within a portfolio. Having too much exposure to specific sectors, assets, regions can create systemic risks for that portion of the portfolio. Hidden risk can occur when assets do not seem correlated but are affected by the same economic forces. For example, Chinese equities, commodities and emerging market currencies would all be affected by a downturn in the Chinese economy.

Interest rate risk and currency risk both affect any portfolio. All assets in a portfolio should be analysed to determine their exposure to interest rates and currencies.

How to measure the risk of your investment portfolio

Risk / Reward Ratio
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There are numerous approaches to measuring portfolio risk. All have their advantages and drawbacks. There is no full proof method, so several methods are usually combined. Volatility is the most common proxy for risk – though there are risks that volatility does not capture. Standard deviation is the typical way to measure volatility. This applies to individual securities and to portfolios.

The return of a portfolio can be calculated by simply averaging the weighted returns. Calculating the standard deviation of a portfolio is a little more complicated. A portfolio’s historical standard deviation can be calculated as the square root of the variance of returns. But when you want to calculate the expected volatility, you must include the covariance or correlation of each asset.

Calculating the correlation and covariance for each stock can become very complicated. The covariance must be calculated between each security and the rest of the portfolio. The weighted standard deviation for each security is then multiplied by the covariance. This will usually result in the portfolio’s volatility being lower than most of its components.

Trading Graph / Chart
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The Sharpe ratio normalizes returns for a given level of risk. This allows one to compare investments and determine the return for every dollar of risk taken. The Sortino ratio is similar, but only considers downside volatility. These ratios can be used for the performance of model portfolios, real portfolios and individual securities. However, they are backward looking, and cannot predict future risk and return.

Beta gives an indication of the riskiness of an individual security relative to the market. The overall market has a beta of 1. A stock with a beta of 1 would be expected to move up and down the same amount as the market. A stock with a beta of 0.5 would only be expected to rise or fall half as much as the market. A stock with a beta of 2 would be expected to rise and fall twice as much as the market.

The beta of a portfolio is calculated as the weighted average of each component’s beta. A portfolio with a high beta means you may be risking more than you think you are. If your portfolio has a beta of 1.5, and the market falls 10%, your portfolio would be expected to fall 15%.

Value at risk (VaR) is used to calculate the maximum loss a portfolio can be expected to lose in a given period. The result is calculated for a specific level of confidence, usually 95 or 99%. There are two methods of calculating VaR – using either a normal distribution, or simulations. VaR is widely used for quantifying risk by banks and regulators. However, it has also been widely criticised and is no longer used by portfolio managers very often.

How to manage the risk of your investment portfolio

Manage Risk Investment Portfolio
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There are several ways to limit portfolio risk. In most cases more than one approach is combined. The stock market has historically generated the highest returns but has also experienced the greatest volatility. For this reason, diversifying investments across several asset classes is the first step in managing a portfolio’s risk. A substantial percentage of most portfolios should be invested in equities, but this needs to be balanced with other types of assets.

A basic diversified portfolio would include stocks, bonds and cash. Stocks provide the greatest long-term returns, bonds provide predictable income, and cash offers immediate liquidity. While this would be a vast improvement on a single asset portfolio, risk can be further diversified with other asset classes. The objective then is to find assets that have very low correlations with equities and bonds.

Commodities / Alternative Assets
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This brings us to alternative assets. These are assets that provide long term capital growth, but relatively low correlation with equities. Real assets like commodities and real estate are more resilient to inflation than other assets. Their intrinsic value depends on physical supply and demand, rather than on the complex dynamics that drive financial assets.

Private equity and venture capital funds come with varying degrees of risk. These types of investments are illiquid, and their values are only calculated monthly or even quarterly. This would usually be viewed as a disadvantage. However, in the context of managing portfolio volatility, it can be an advantage. The value of these funds doesn’t fall during market corrections which result in volatility across other asset classes.

Hedge funds are the only asset class specifically created to generate uncorrelated returns. Hedge funds use a wide variety of strategies to generate returns that are not dependent on market performance. They also use short selling, leverage and derivatives to capture alpha.

Data Intelligence Fund
Data Intelligence Fund managed by Catana Capital

Some hedge funds use unconventional methods to find opportunities that other types of funds cannot exploit. An example is Catana Capital’s Data Intelligence Fund which combines big data, A.I., and market sentiment to find overlooked opportunities in real time.

In many cases hedge funds are the only types of investment funds that can protect capital during major bear markets. The only way to protect a fund from a black swan event is by using funds with inverse or neutral exposure to equity markets. Diversification is usually considered in the context of asset classes. However, diversification can also be done by investment style and by timeframe.

Traditionally most portfolios were made up of share portfolios and mutual funds. However, the popularity of ETF investing has resulted in a much wider range of low-cost funds being made available to investors. Commissions have also declined making diversification by time more affordable. The growing recognition of quantitative investing and factor investing means portfolios can be diversified across numerous factors and styles.

Modern Portfolio Theory
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Modern portfolio theory is one process that can be used to construct a portfolio that maximizes the expected return for a given amount of risk. This is done using mean variance optimization. The objective is to combine stocks in such a way as to reduce portfolio volatility as much as possible. A series of simulations is done to maximise the portfolio’s expected return for a given level of risk. This approach works very well for stock portfolios. Other methods are then used at the asset allocation level.

The risk parity approach is similar but is done at the asset class level. Asset classes are weighted so that their contribution to overall portfolio risk is equal. If for example equities are four times more volatile than bonds, the bond weighting will be four times the equity weighting. Risk parity is associated more with capital preservation than with earning alpha.

Conclusion: Diversify your portfolio across various asset classes

Understanding and managing portfolio risk is perhaps the most important role within portfolio management. Asset allocation decisions will have the greatest impact on the risk a portfolio will face.Being able to quantify the risk of a portfolio allows investors to optimize potential returns. The more risk can be quantified and managed, the more capital can be allocated to riskier assets that generate the highest returns.

About Richard Bowman
Richard Bowman is a writer at Catana Capital, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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