Every financial investor will encounter a trade-off between returns and risks. The reward for greater risk is greater returns. However, it would be best to consider your risk appetite before making any investment.
Each investment has a different level of risk. The more you diversify your investments in your portfolio, the lower your overall risk will be. Let us understand what affects the performance of assets and how you can quantify the amount of risk you may face.
What is portfolio risk?
Portfolio risk is the total risk determined by the individual risk associated with each asset you hold in your portfolio. The assets you own may fail to perform financially as expected. As a result, it leads to a substantial amount of loss. There are multiple causes for it and different ways to mitigate each category of risk. Let us see what the various types of risks are.
Types of portfolio risks
Risks involved with individual securities
To understand the overall risks involved in portfolios, let us first see the risks involved with individual securities.
Liquidity risk
It is the risk of not fulfilling short-term obligations on time. Short-term obligations are those that are due within a year.
Political and regulatory risk
It is when an investor suffers financially due to any sort of political flux in the country.
Default risk
It is a type of risk where a borrower cannot pay off his debts to the lender on time. Once a specific time has passed without any repayment, the loan converts to bad debt.
Style risk
It is a type of risk that is associated with your style of investing.
Duration risk
It is the risk associated with the time horizon of your investment. Over a period of time, you can find differences in interest rates. Eventually, the market value will either increase or decrease according to these fluctuations.
As you know, a portfolio is a combination of individual securities. However, certain kinds of risks are exclusively associated with the overall portfolio. Let us have a look at those.
Risks involved with the overall portfolio
The following risks affect the portfolio as a whole:
Systematic or market risk
It refers to the risk that affects the whole market or its segments. It is also known as volatility, undiversifiable, or market risk. The name undiversifiable implies that you cannot reduce this risk by adding a range of securities to your portfolio. It affects everyone in the market alike.
Unsystematic risk
This is also known as diversifiable risk. It is associated with a single company, market, or sector. You can mitigate this risk by diversifying your portfolio and adding various asset classes. In such a case, a loss in one sector may be offset by a gain in another. This reduces the overall risk of your portfolio.
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Inflation risk
Also known as purchasing power risk, this occurs when the price of a commodity or a product increases to an unexpected price. Inversely, the prices may even fall below an expected level.
Concentration risk
This risk refers to the chances of an investment portfolio losing value when an individual or company moves in an unfavorable direction. The probability of facing this risk is higher when you have a less diverse portfolio, implying that your focus is on a small set of securities.
Reinvestment risk
It is a type of risk where an investor is unable to reinvest cash flows from their investment at a rate equivalent to the current rate they are receiving. This kind of risk is the highest in bonds. However, if they are zero-coupon bonds, there is no such risk involved due to no payments as coupons.
Currency risk
It occurs due to fluctuations in the exchange rates. This involves the movement of one currency against another currency, affecting those who operate or invest internationally.
Interest rate risk
This kind of risk is associated with the changes in the interest rate on various securities, primarily fixed-income securities. There is an inverse relationship between interest rates and bond prices. An increase in interest rate may result in losses due to a fall in the value of the assets.
Now that you have understood the risks involved with individual securities and overall portfolios, let us know the calculation to determine the level of risk.
How to measure portfolio risk?
You can measure risk in a portfolio by determining its standard deviation. However, it is not one hundred percent sufficient for calculating risks as a whole. You must also assess the correlation and covariance among various assets in the portfolio. It helps determine the direction of movements in the asset’s value and thus the overall effective risk. You can calculate portfolio risk as follows:
Portfolio Risk = Sqrt {[(w1)^2 * (SD1)^2] + [(w2)^2 * (SD2)^2] + 2(w1*w2*Correlation between asset 1 and asset 2*SD1*SD2)}
Or
Portfolio Risk = Sqrt {[(w1)^2 * (SD1)^2] + [(w2)^2 * (SD2)^2] + 2(w1*w2*Covariance between asset 1 and asset 2)}
Here, w1 and w2 are the weights associated with each investment, depending on the amount invested.
Let us explain this using an example.
You have invested a total of Rs. 10,000 in two stocks. You put Rs. 3,000, i.e. 30% of the amount in asset 1 and the remaining 70% in asset 2. The standard deviation of assets 1 and 2 is 12 and 15 respectively. The correlation between the two is -1.
Here, the weights are given as w1=0.3 and w2=0.7. Putting all the values in the formula given above, the calculated portfolio risk comes out to be 6.9 in this case. The portfolio risk will be calculated as:
Portfolio Risk = Sqrt {[(0.3)^2 * (12)^2] + [(0.7)^2 * (15)^2] + 2(0.3*0.7*-1*12*15)} = 6.9
A correlation of +1 means that both of these stocks will rise and fall conjointly. Conversely, a correlation of -1 shows an inverse movement.
Another investment option is putting your money in fixed-income securities. These come with a lower level of risk. Read our blog here to learn more about the risk and return on such securities.
In conclusion
Understanding the level of risk involved in your portfolio is necessary to manage your portfolio better. It allows you to diversify into a variety of asset classes, some of which are high-risk, high-return securities. This is offset by including safer investments that reduce the overall risk. If you can quantify the amount of risk, you can get much better returns.
We at TejiMandi are a group of sebi-registered professionals who can help you accurately calculate the risk of your portfolio. We also are wealth management experts and can curate the best portfolio for you to maximise your returns considering your risk profile.
