PORTFOLIO

RISK ANALYSIS
 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
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.
To pr oper l y det er mi ne your r i sk t ol er ance, you shoul d s peak t o a f i nanci al advi s or . You can
al s o us e one of t he t ool s weal t h manager s of t en i ncl ude on t hei r webs i t es . You can
however get an i dea of your r i sk t ol er ance by consi der i ng your por t f ol i o val ue, t i me
hor i z on, mont hl y i ncome, mont hl y expenses and t he r el i abi l i t y of your i ncome. You s houl d
al s o cons i der your t emper ament and how much you ar e ps ychol ogi cal l y pr epar ed t o l os e.

Ri s k t ol er ance can be r at ed as hi gh, moder at e or l ow. I f you ar e at l eas t 20 year s of f

r et i r ement age, have a r el i abl e i ncome st r eam and some cas h s avi ngs , your r i s k t ol er ance
wi l l be hi gh. I n t he cas e of a mar ket cr ash you wi l l have t i me f or t he mar ket t o r ecover and
you won’ t need t o dr aw f r om your por t f ol i o. On
t he ot her hand, i f you ar e appr oachi ng
r et i r ement age or may l os e your sour ce of i ncome, your r i s k t ol er ance wi l l be l ow. Los i ng
money on your por t f ol i o cl ose t o, or dur i ng r et i r ement , wi l l r es ul t i n dr awi ng capi t al f r om
an i mpai r ed por t f ol i o.

Ri s k t ol er ance i s cl os el y r el at ed t o r i sk appet i t e and r i s k capaci t y. Your r i s k t ol er ance wi l l

change onl y gr adual l y over t i me. At any gi ven t i me, i t wi l l di ct at e your r i s k capaci t y. Ri s k
capaci t y can al s o be t hought of as t he amount of r i sk t hat mus t be t aken t o achi eve
i nves t ment goal s . Ri s k appet i t e consi der s bot h t ol er ance and capaci t y, and t he i nves t ment
l ands cape at any gi ven t i me.
 Types of portfolio risks
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.
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
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.
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
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.
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.
Some hedge funds use unconventional methods to find opportunities that other types of funds
cannot exploit. An example is Lehner Investment’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 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.
 Thank
!you !
SUBMITTED BY : SANA MASOOD
(BBDITM)
SUBMITTED TO : MR. SHASHANK
RAO