Portfolio Risk Management
June 15, 2023
What is Portfolio Risk Management?
Portfolio risk management is the process of identifying, measuring, and addressing the potential risks that could have an impact on the overall performance of a portfolio. Some examples of portfolio risk include:
- Company-Specific Risk – the possibility that a single holding could perform poorly
- Foreign Currency Risk – currency fluctuations could have a negative impact on returns
- Liquidity Risk – the possibility that an investment might not be sold readily without affecting the market price
- Interest Rate Risk – a movement in interest rates could negatively affect investment value
- Inflation Risk – rising prices could have a negative impact on the value of portfolio holdings
- Systematic Risk – market risk, which cannot be avoided
- Climate Risk – the impact of climate change could have a negative impact on holdings
To mitigate risk, investors can select from a range of strategies intended to deliver the optimal risk-return profile.
Key Learning Points
- Portfolio risk management is a dynamic process of identifying and managing all risks that can impact portfolio value.
- Portfolio structure, including asset allocation and security-specific characteristics, are key in determining and managing risk.
- Common measures of risk include standard deviation, beta, tracking error, and drawdowns.
- Standard risk management strategies include diversification, hedging, and asset allocation as well as using a risk budget and establishing target sell prices.
How to Measure the Risk of a Portfolio
Common portfolio risk measures include:
Standard Deviation
Standard deviation is an expression of volatility that is a statistical measure of the variability of returns around the average return of an investment. The higher the standard deviation, the higher the risk of an investment.
Tracking error
Tracking error is a measure of active risk and shows the deviation of portfolio returns from an established benchmark. Higher tracking error means higher risk. Tracking error is calculated as the standard deviation of active returns:
Where:
Ri – return on the investment
Rb – return on the benchmark
n – the number of observations
Tracking Error Example
Below is performance data for large-cap US mutual fund and the benchmark index. Calculate the Tracking Error for Fund A, using the tracking error equation.
Download the step-by-step tracking error calculation files to work through this calculation and access the full file to check your workings.
Beta
Beta measures the sensitivity of portfolio returns to changes in the market. A beta of 1 indicates that returns move in line with the market, while a higher beta means higher sensitivity and volatility of returns and a lower beta indicates less sensitivity to market movements.
Drawdown
Drawdowns can be split in two categories. Maximum drawdown measures the decline in value of an investment from its peak value, where average drawdown is the average of the yearly Max Drawdown measures (a downside risk measure for the Sterling Ratio – a risk-reward ratio mainly used in the context of hedge funds) over a specific period (most commonly over three years). Larger drawdowns typically indicate higher loss potential and higher risk.
Where:
P – peak value before largest drop
L – lowest value before new high established
Along with those statistical measures, investors also pay close attention to the constituents, their features, and how they might influence potential returns. For example, equity portfolios are typically measured against a market index and their typical peer group average. Should a portfolio exhibit higher exposure to mid and small cap companies, specific sectors, geographic regions, or investment style (value or growth), it is considered higher risk.
For more specialist strategies such as o “special situations” stocks (i.e., companies that are experiencing short-term disruptions to their operations or revenues or are undergoing a structural change), measures like the average debt-to-capital (or leverage ) of the portfolio could provide a better perspective on risk.
Portfolio Risk Tolerance
The level of risk that an investor is willing to accept is called portfolio risk tolerance. It is influenced by many factors, including:
- Investment horizon
- Investment objectives
- Income requirements
- Personal characteristics
Investors with higher risk tolerance may accept higher volatility and typically have a longer investment horizon, while more risk averse investors prefer lower volatility and may accept potentially lower returns.
In terms of asset allocation, younger investors typically have a larger proportion of their funds in equities, while those with shorter time horizons allocate more to lower risk assets such as bonds. On the other hand, investors who require regular income may opt for equity income portfolios, bonds, or a mix of the two depending on risk tolerance.
The chart above illustrates the efficient frontier, which is the array of optimal portfolios that offer the highest expected return for a given level of risk, or the lowest level of risk for a given level of expected return.
Portfolio Risk Management Strategies
Some of the most used portfolio risk management strategies include:
Diversification
A diversified portfolio spreads risk by investing in a larger number of securities and across multiple asset classes, geographic regions, and sectors with the intent of offsetting the impact of a single investment performing poorly. The table below shows returns for various asset classes and highlights the importance of maintaining a diverse mix of assets in a portfolio.
Hedging
Hedging involves taking a position in a security or derivative that will offset potential losses in another investment. For example, an investor may buy a put option (the option to sell a security at a specified price on a specified date) on a stock or stock market index to protect themselves against a potential decline in the security’s value. Currency hedging, for example, seeks to protect a portfolio against the risk of underlying currency fluctuations.
Hedging Example
The chart below shows the 5-year risk-return profile for the MSCI ACWI index, which includes approximately 3000 large-cap stocks across both developed and emerging markets.
Over five years, investors who opted for the currency-hedged version of the index benefited from higher total returns and lower volatility.
Risk Budgeting
This strategy is designed to be consistent with risk tolerance and investment objectives and therefore may be quite subjective. It involves allocating risk across different investment strategies or asset classes.
Asset Allocation
Asset allocation apportions a portfolio among different asset classes (for example equities, bonds, real assets, alternatives) consistent with the investor’s risk tolerance, investment objectives, and time horizon.
Using Price Targets
This strategy uses a stop loss order to automatically sell a security when the price reaches a certain target. The target price is usually calculated as part of a discounted cash flow or DCF analysis). This approach can insulate a portfolio against sharp declines.
Other considerations include currency exposures, sources of underlying revenues, factor exposures, and market capitalization. In addition, establishing weighting limits, for example, no more than 5% in an individual security, no more than 20% in a single sector, or no more than 35% invested in a single geographical region, as well as regular rebalancing, also help to mitigate risk.
Conclusion
Portfolio risk management is an essential part of the investment process, with the objective of limiting the potential downside of a portfolio. While some risks, market risk, for example, cannot be avoided, there are various others, such as currency or stock-specific risks, that can be controlled by using a variety of risk management strategies. Depending on an investor’s time horizon and objectives, achieving an optimal asset mix balance is key. Risk management is a dynamic and evolving process.