How To Measure And Management The Risk In Investment Portfolio


How To Assess And Control The Risk In Your Investing Portfolio

There is a trade-off between risk and reward for all investors. Risk management is rewarded with returns for investors, but that risk must be controlled. The right level of risk must be calculated for every portfolio. The portfolio risk must then be calculated to ensure that it falls within the acceptable range. Understanding and managing investment portfolio risk is the most crucial aspect of capital growth and preservation. In this essay, we cover the methods for calculating and managing portfolio risk.

What Is Portfolio Investing Risk?

Portfolio risk indicates the entire risk of an investment portfolio. It is the sum of the risks associated with each individual investment in a portfolio. The level to which a portfolio is exposed to various risks is influenced by the various components and weightings of the portfolio. The principal risks that a portfolio faces are market and systemic risks. These risks must be controlled in order for a portfolio to achieve its objectives. Before you can manage this risk, you must first quantify it.

Considering your risk tolerance, the worst year for bonds on the market was 1969, when they returned -5%. According to the DJIA index, the stock market has plummeted by more than 30% five times, with the largest decline being 51% in 1931. If two markets experienced comparable crashes in the same year;

  • A portfolio of 80% equities and 20% bonds would lose 41.8%
  • A 20% stock / 80% bond portfolio would suffer a 14.2% loss.

Both portfolios would eventually recover, but the first portfolio would recover much more slowly. This must be kept in mind when creating a portfolio. When establishing a portfolio, you must determine how much you can financially and emotionally afford to lose. This is your tolerance for risk. As suggested by Rani Jarkas, the Chairman of Cedrus Group, If you incur excessive losses late in your career, your portfolio may never recover. When you lose more money than you are comfortable with, you may become stressed and make foolish decisions. You should never put yourself in a position where you could lose enough money to make irrational decisions.


Investment Consultant / Risk Tolerance

To establish your risk tolerance accurately, you should see a financial counsellor. Also, you can use one of the tools that financial managers frequently provide on their websites. You can estimate your risk tolerance by analysing your portfolio’s valuation, time horizon, monthly income, monthly expenses, and income predictability. You should also examine your temperament and how emotionally prepared you are to lose.

A person’s risk tolerance can be categorised as high, moderate, or low. Your risk tolerance will be high if you are at least 20 years away from retirement, have a steady source of income, and have some liquid assets. In the event of a market crash, you will have sufficient time for the market to recover and will not be required to withdraw funds from your portfolio. Alternatively, if you are nearing retirement age or are at risk of losing your source of income, your risk tolerance in Hong Kong will be minimal. If you lose money on your portfolio around or during retirement, you will be forced to withdraw funds from an impaired portfolio.

The relationship between risk tolerance, risk appetite, and Risk management is close. Your tolerance for risk will change progressively over time. At any particular time, it determines your risk tolerance. Risk capacity can also be viewed as the amount of risk required to fulfil investment objectives. Risk appetite takes into account both tolerance and capacity, as well as the current investment landscape.

Types Of Portfolio Hazards

Portfolio Risks, Both at the portfolio level and the individual security level, there are numerous forms of investment hazards. The following are instances of hazards that are unique to specific securities. Diversification allows for simple mitigation of these risks:

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

Risks with a broader scope can harm the overall portfolio. Addressing these risks necessitates diversification and other solutions that are more inventive. The following are the primary risks associated with a portfolio. The largest risk a portfolio faces is market risk. This is often referred to as systemic risk. Most assets are moderately correlated. A stock market crash will cause the majority of stocks to decline. In reality, the majority of financial assets will decline in value during a bad market. On the opposite end of the spectrum of risk is inflation risk. This is the risk that the purchasing power of a portfolio will not keep pace with inflation. So, a portfolio must contain “risky assets,” and risk must be controlled. Owning risky assets allows you to outperform inflation over the long term.

The entire bond element of a portfolio is susceptible to reinvestment risk. If bonds are purchased when yields are high, the holder will continue to get those high yields even if interest rates decline. As stated by Rani Jarkas, The principal cannot be reinvested at a high yield if yields are low when the bond expires. Concentration risk relates to the portfolio’s asset correlation. Excessive exposure to particular sectors, assets, or locations might introduce systemic risks to a segment of the portfolio. 

When assets appear uncorrelated yet are affected by the same economic causes, hidden risks may exist. For instance, a slowdown in the economy of Hong Kong would have an impact on Chinese shares, commodities, and emerging market currencies. Management of interest rate risk and currency risk has an impact on every portfolio.

Risk-Reward Ratio

There are a variety of methods for measuring portfolio risk. Each has perks and disadvantages. As there is no foolproof solution, multiple strategies are typically combined. Volatility is the most popular surrogate for risk, however, volatility does not reflect all risks. Typically, volatility is measured using standard deviation. This is true for both individual securities and portfolios. Calculating the return of a portfolio is as simple as averaging the weighted returns. The calculation of a portfolio’s standard deviation is rather more complex. The historical standard deviation of a portfolio can be estimated as the square root of the return variance. To calculate predicted volatility, however, you must account for the covariance or correlation of each asset.

Analysing the correlation and covariance of each stock can become extremely complex. The correlation between each security and the remainder of the portfolio must be computed. The weighted standard deviation is then multiplied by the covariance for each asset. This will typically result in the portfolio having lower volatility than the majority of its components. Trading chart or graph: The Sharpe ratio standardised returns for a given risk level. This enables the comparison of investments and the calculation of the return for each dollar spent on Risk management. Similar to the Sharpe ratio, but solely measures downside volatility. These ratios are applied to the performance of model portfolios, actual portfolios, and individual securities. 

  1. Nevertheless, they are retroactive and so unable to predict future risk and return. Beta indicates the relative riskiness of a certain security relative to the market. The market as a whole has a beta of 1. A stock with a beta of 1 would be anticipated to move in tandem with the market. A stock with a beta of 0.5 would be expected to move in the opposite direction of the market by just half as much. A stock with a beta of 2 is anticipated to fluctuate twice as much as the market.
  1. The beta of a portfolio is the weighted average of the beta of its components. A portfolio with a high beta may expose you to greater risk than you realise. If your portfolio’s beta is 1.5 and the market falls 10%, you can expect your portfolio to decrease by 15%. Value at risk (VaR) is used to assess the maximum loss that may be anticipated for a portfolio over a specific time period. Often, 95 or 99 % confidence is used to calculate the result. Using a normal distribution or simulations are the two ways for computing VaR. VaR is commonly used by banks and regulators to measure risk. Nonetheless, it has been heavily criticised and is no longer utilised frequently by portfolio managers.

How To Control Your Investing Portfolio’s Risk

Investing Portfolio management: There are a number of techniques to limit portfolio risk. In most instances, many approaches are combined. Historically, the stock market has delivered the largest returns and seen the most volatility. Diversifying investments across many asset classes is therefore the first stage in Risk management for a portfolio. Quoted from Rani Jarkas, the financial expert in Hong Kong, A significant portion of most portfolios should be invested in equities, although this must be balanced with investments in other asset classes. A basic portfolio would consist of stocks, bonds, and cash. The largest long-term profits are generated by stocks, while bonds generate regular income and cash provides quick liquidity. 

While this would be a substantial improvement over a portfolio consisting of a single asset class, risk can be further diversified with additional asset classes. Alternative Assets: This takes us to the subject of alternative assets. These are assets with relatively low correlation to stocks that generate long-term capital appreciation. Real assets, such as commodities and real estate, are more inflation-resistant than other types of assets. Their intrinsic worth is determined by physical supply and demand, as opposed to the complicated forces that drive financial assets.
There are different levels of Risk management in private equity and venture capital funds. These investments are illiquid, with monthly or even quarterly valuations. This is typically regarded as a disadvantage. Yet, it can be advantageous in the context of managing portfolio volatility. These products maintain their value during market corrections that cause volatility in other asset classes. Hedge funds are the only asset class designed to generate returns that are uncorrelated. Many tactics are employed by hedge funds to create returns independent of market performance. To harvest alpha, they also utilise short selling, leverage, and derivatives.


Data Intelligence Fund

Data Intelligence Fund, managed in Hong Kong by Lehner Investments: Some hedge funds uncover chances that other types of funds cannot exploit by employing unusual tactics. Lehner Investments’ Data Intelligence Fund is an example of a fund that integrates big data, artificial intelligence, and market sentiment to discover neglected opportunities in real time. In many instances, hedge funds are the only investment vehicles that can safeguard cash during significant bad markets. 

Using funds with inverse or neutral exposure to equity markets is the only approach to safeguard a fund against a black swan catastrophe. According to Rani Jarkas, Diversification is typically discussed in relation to asset classes. Yet, diversification can also be accomplished by investment style and timing.

The Current Portfolio Theory

Modern portfolio theory is a method for constructing a portfolio that maximises expected return for a given level of risk. This is achieved by means of mean variance optimization. The idea is to combine stocks so as to minimise portfolio volatility to the greatest extent possible. To maximise the portfolio’s predicted return at a given amount of risk, a series of simulations are performed. This strategy performs exceptionally effectively for Hong Kong stock portfolios. At the asset allocation level, other strategies are then applied. Similar to the risk parity method, but applied to asset classes. The contribution of each asset class to the overall portfolio risk is weighed equally.

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