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How to calculate and manage the portfolio risk


by Valerio Sabelli

Every day, each of us is exposed to a number of risks and experience them more or less consciously. However, at the time of approaching to the world of investments, it is crucial to start to understand which is your risk profile and, accordingly, to identify the best strategy for your own portfolio risk management

The objective is predictable, but well defined: you are willing to “bet” on high-risk investments, in order to have the greatest potential in premium, but only in some cases.

Let’s find out what are the common scenarios and what are the parameters according to which to choose between the various investment solutions.

What is a portfolio risk

The portfolio risk is defined within the realm of finance as the possibility that the final results of an investment differ from an expected revenue (return), covering – in some cases – the entire investment.

Risk is usually estimated by considering the historical behavior of financial assets and their revenues or losses. In particular, the statistical quantity that is commonly associated with the risk is the standard deviation, which provides a measure of price volatility compared to the historical averages over a specified period of time under analysis. High volatilities correspond to high degrees of risk.

How to manage the portfolio risk

Companies, financial advisors or individuals can implement different risk management strategies.

The first aspects to be consider in our portfolio risk analysis are the time horizon and the liquidity of the investment. If a company needs to quickly regain control of the funds, it will not most likely be appropriate to invest in high-risk securities or that cannot be immediately settled; rather, it will focus on low-risk assets.  

Instead, younger investors with broader time horizons might focus on higher revenues, contemplating high risks at the same time. 

An indicator that must be taken into account during the selection of our investments is the Morningstar Rating: we refer to a fund categorization based on investment policies similar to each other and on the basis of the securities structure analysis. This rating also takes into account the costs of commissions and the regularity of returns over time (therefore, it does not consider as best those with even higher, but fluctuating, returns). The final result will be a number of stars, from 1 to 5, updated on a monthly basis. 

Another necessary classification is that between the types of risk. Here below some of the main ones:

  • business risk: will the company we invest in be able to cover initial and operational expenses (salaries, rents, production costs) thanks to sales, generating profits?
  • credit risk: will a debtor be able to repay the contractual interest and the monthly loan share? In this case, government bonds are characterized by less risk (lower probability of default), but also by low yields, in contradistinction from bonds issued by companies.
  • country risk or political risk: is the State whose we own bonds at risk due to the financial soundness of that country? Is there any risk of overturning or political instability in that country? 

In the end, a special mention goes to diversification. Having a portfolio in which investments are appropriately distributed will lead to minimization of the correlation between investments (especially between their revenues). As a consequence, the collapse of a certain type of investment will hopefully have lower impacts on the other assets. Diversification can be done in terms of risk (assets with higher or lower risk) or in terms of sector, industry or geographical region.

Obviously, this securities balancing operation should not only be carried out at the initial stages, but it should be updated periodically, also according to news and financial rumors. 

The right and the most suitable combination for our business needs is the winning formula for the proper balance between revenues and risks.