How to determine portfolio risk?

Every financial investor will encounter a trade-off between returns and risks. The reward for greater risk is greater returns. However, it would be best to consider your risk appetite before making any investment.

Each investment has a different level of risk. The more you diversify your investments in your portfolio, the lower your overall risk will be. Let us understand what affects the performance of assets and how you can quantify the amount of risk you may face.

What is portfolio risk?

Portfolio Risk is the total risk determined by the individual risk associated with each asset you hold in your portfolio. The assets you own may fail to perform financially as expected. As a result, it leads to a substantial amount of loss. There are multiple causes for it and different ways to mitigate each category of risk. Let us see what the various types of risks are.

Types of portfolio risks

Risks involved with individual securities

To understand the overall risks involved in portfolios, let us first see the risks involved with individual securities.

Liquidity risk

It is the risk of not fulfilling short-term obligations on time. Short-term obligations are those that are due within a year.

Political and regulatory risk

It is when an investor suffers financially due to any sort of political flux in the country.

Default risk

It is a type of risk where a borrower cannot pay off his debts to the lender on time. Once a specific time has passed without any repayment, the loan converts to bad debt.

Style risk

It is a type of risk that is associated with your style of investing.

Duration risk

It is the risk associated with the time horizon of your investment. Over a period of time, you can find differences in interest rates. Eventually, the market value will either increase or decrease according to these fluctuations.

As you know, a portfolio is a combination of individual securities. However, certain kinds of risks are exclusively associated with the overall portfolio. Let us have a look at those.

Risks involved with the overall portfolio

The following risks affect the portfolio as a whole:

 

Systematic or market risk

It refers to the risk that affects the whole market or its segments. It is also known as volatility, undiversifiable, or market risk. The name undiversifiable implies that you cannot reduce this risk by adding a range of securities to your portfolio. It affects everyone in the market alike.

Unsystematic risk

This is also known as diversifiable risk. It is associated with a single company, market, or sector. You can mitigate this risk by diversifying your portfolio and adding various asset classes. In such a case, a loss in one sector may be offset by a gain in another. This reduces the overall risk of your portfolio.

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Inflation risk

Also known as purchasing power risk, this occurs when the price of a commodity or a product increases to an unexpected price. Inversely, the prices may even fall below an expected level.

Concentration risk

This risk refers to the chances of an investment portfolio losing value when an individual or company moves in an unfavourable direction. The probability of facing this risk is higher when you have a less diverse portfolio, implying that your focus is on a small set of securities.

Reinvestment risk

It is a type of risk where an investor is unable to reinvest cash flows from their investment at a rate equivalent to the current rate they are receiving. This kind of risk is the highest in bonds. However, if they are zero-coupon bonds, there is no such risk involved due to no payments as coupons.

Currency risk

It occurs due to fluctuations in the exchange rates. This involves the movement of one currency against another currency, affecting those who operate or invest internationally. More about Default risk