Portfolio Risk: Definition and Types

Portfolio Risk: Definition and Types

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Key Takeaways: When investing, high returns and high risks go hand in hand. When you invest across various assets, you are doing both, taking and mitigating your investment risks. That risk is widely known as Portfolio Risk. By strategically investing across assets, you can lower your risk and enjoy lucrative returns.

Introduction

An investment is deemed to be profitable if it can generate high returns. A salient feature of any investment is that high returns equal high risks. The primary classes of assets you can invest in are equity (stocks), debt (bonds), precious metal and other commodities, and real estate.

Now consider two individuals, Mr. X and Ms. Y. Mr. X only knows that by investing in the stock market, he will gain high returns and so decides to invest only in the stock market. Ms. Y knows her way around the stock market. She knows that high returns will entail high risks. Keeping this in mind, she decides to invest in bonds. (When compared to stocks, bonds are always safer but with their own risk factors.) Days later, the stock market crashes. Mr. X and Ms. Y both have incurred losses with their investment in the stock market. But Ms. Y is relieved because this impact is absorbed by her safety net, i.e., her investment in bonds.

To infer, by investing in more than one asset, Ms. Y could recuperate her loss with her knowledge of portfolio risk.

What is a Portfolio Risk?

When you invest in a combination of assets, you create an investment portfolio. Now, like every investment, either of the things can happen – you could reap decent returns and fulfil your financial goals, or you could incur losses. There is a chance or a risk that your portfolio may not meet all your financial goals, and this is known as a Portfolio Risk. There are ways to make your portfolio secure from these risks, but in reality, these risks can only be minimised.

What are the types of Portfolio Risks?

There is no one singular factor that affects investment portfolios. Following are some examples of risks associated with your investments.

Market Risk

The greatest of all risks any portfolio could face is the market risk, also known as systematic risk. As the name suggests, this risk exists due to the volatility of the market. Furthermore, types of market risk include equity risk, interest rate risk and currency risk.

  • Equity Risk: The risk of losing out on money due to a drop in the stock market.
  • Interest Rate Risk: The risk of loss due to change in interest rate in case of debt investments.
  • Currency Risk: The risk of loss due to fluctuation in the exchange rate, applicable to foreign investments.

Liquidity Risk

Liquidity risk is when you are unable to sell your investments because of the low market values of the investment when you need funds. This can be quite problematic when you need cash during emergencies.

Concentration Risk

The risk of losing your money because you decided to invest all your money in only one type of asset, such as the stock market, is known as concentration risk. A good investment portfolio does not invest only in just one asset.

Credit Risk

Applicable for debt investment (bonds), credit risk is when the company that issued the bonds faces financial difficulties. Always check the credit ratings of bonds before investing.

Reinvestment Risk

Reinvestment risk occurs in the event of declining interest rates. For example, you invest in bonds at a specific interest rate and gain high returns. But with falling interest rates, you are unable to reinvest and avail that initial interest rate which gave you high returns previously.

Horizon Risk

Horizon risk is when you decide to invest in an asset for a longer duration, e.g., 10 years. However, due to unforeseen events, you may be forced to sell the investments even if the market is down, resulting in a loss.

Risk Tolerance

When you decide to create a portfolio, you must be ready to face losses. The threshold at which you cannot afford any losses will be considered as your risk tolerance. The time of your investment plays an essential role too. If you are nearing retirement, where you have feeble chances of monthly income to cater to your lifestyle, your portfolio may never recover, as opposed to your earlier days.

If you are an individual who has a long way to go before retirement, and if you have a steady income source and some savings hither and thither, you will potentially have higher risk tolerance. However, if you are close to retiring and about to lose a steady income flow, you will have lower risk tolerance. Losing money puts you in a stressful situation resulting in irrational decisions and an impaired portfolio. You can gauge your tolerance by studying your portfolio and analysing your monthly income and expenses, investment horizon or, you can seek help from a financial advisor.

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How to Calculate Portfolio Risk?

There are many mathematical ways to identify portfolio risk. But let us briefly learn about it.

You can calculate the risk of an individual investment by using the Standard Deviation method. Standard Deviation statistically measures the variation of specific returns to the average of those returns. The portfolio risk is also measured by taking the Standard Deviation of variance of actual returns of that portfolio over time. The variability of returns is proportional to the portfolio's risk. This risk can be measured by calculating the Standard Deviation of this variability.

Portfolio risk calculations are conducted by experts in the field. As an investor without a solid finance and accounting background, you are not expected to know the math. What you must, however, know are the ways to reduce your portfolio risks.

How to Reduce Portfolio Risk?

As mentioned previously, you cannot eradicate the risk but minimise it. The stock market does both – gives high returns and experiences high volatility. Hence, your primary concern should be to diversify your portfolio by investing across various asset groups. Stocks with their long-term returns, bonds with their stable returns, gold with its appreciation component, and a permutation-combination of these assets will serve you better than investing in only one asset.

Modern Portfolio Theory (MPT) is an investment term used in reference to the portfolio building process. The idea is that investors will always want high returns with minimum risk. Investors will look for investments with returns where the risk and volatility are particularly low. The way this risk is lowered is by investing in non-correlated assets. If an asset linked with high risk is paired with an investment whose value rises with the downfall of other investments, the risk of the overall portfolio is low.

You can add liquid assets to your portfolio as well. Let us say that you need money urgently, and your highly volatile investment is performing poorly. However, you are left with no option than to sell that investment. This will result in a substantial loss. High volatility assets perform well with high investment horizons. With liquid assets, you can let the highly volatile assets mature in due time to produce good returns.

Conclusion: Like all things in life, your investments have risks too. Risk in investments could lead to scarring your finances terribly. Since there is no sure shot way to eliminate the risk, you can undoubtedly lower it by diversifying your investments across several assets or allocating assets with the help of an investment professional.

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*Disclaimer: This article is published purely from an information perspective and it should not be deduced that the offering is available from DBS Bank India Limited or in partnership with any of its channel partners.

The purpose of this blog is not to provide advice but to provide information. Sound professional advice should be taken before making any investment decisions. The bank will not be responsible for any tax loss/other loss suffered by a person acting on the above.

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