Portfolio Risk Management

One of the most basic tenets of portfolio risk management is – don’t lose money. Understanding the risk you are assuming and how you intend to mitigate this risk is what separates successful investors from those that never make any money.

There are several types of portfolio investing risk. Knowing the risk is the first step to making better investing decisions.

Macro Risk Categories

In a macro sense, there are two types of risk. Systematic risk, also known as market risk, is the risk associated with the overall market. An example is the overall trend of the stock market dictates a substantial part of the total return. In this case, owning stocks from different sectors does not diversify away from the systematic risk of the market.

You can mitigate systematic risks by hedging your positions with non-correlated assets (much harder to do than most think) or employ good stop management techniques to preserve your capital. While stops are not part of the Modern Portfolio Theory, they have their use and should be part of your overall strategy.

Changes in interest rates, recessions, and major catastrophes are examples of systematic risk as they affect the entire market.

Unsystematic risk, also known as specific risk or diversifiable risk, is the risk inherent in each investment. Investors can offset specific risks with proper diversification.

For example, if you place all your money in a biotechnology company that has just received news that the FDA will not approve a new drug, you have encountered unsystematic or specific risk. This news would cause the share price to fall precipitously.

Had you owned shares of several biotechnology companies or, better yet, companies in other industries, you would have reduced your risk.

On Jim Cramer’s “Mad Money” program, he has a segment titled “Are you diversified?” People call in and give him five stocks they own in various industries. He opines whether there is sufficient diversification in the portfolio. All he is doing is suggesting how to hedge unsystematic risk. Systematic or market risk will remain in the portfolios.

Index Funds

The popular S&P 500 index funds are subject to market risk while diversifying away much of the specific risk of owning a specific stock or sector. $10,000 invested into an S&P 500 index fund on January 4, 2000, would be worth $9,373.09 as of November 30, 2009. This is the effect systematic or market risk had on this investor’s portfolio. The diversification of holding the broad S&P 500 did not keep you from losing money. Instead you felt the sting of owning the market while employing appropriate hedge techniques would reduce or all but eliminate the effect of the losses in owning the market.

Core assets

When examining a complete portfolio, it is imperative to consider fully the essential factors that comprise your core investable core assets. Dr. David Swensen, the Nobel Price winner in economics, has identified three characteristics of core assets that should be part of your evaluation to help reduce systematic or market risk.

  • Use assets to hedge the market risk of other assets. For example, real estate is a good hedge against the ravages of inflation, while bonds offer protection from a financial crisis. By recognizing these inherent characteristics of your core assets, you can hedge some of the market risk inherent in an investment portfolio.
  • There should be fundamentally based market returns from the asset class. If you depend only on active management of the asset class, you are increasing the risk of losses by not investing in the market.
  • Rely on liquid markets where there is a ready market to buy and sell your core asset. Assets that cannot be immediately priced and sold are subject to sudden and deep losses. Liquid markets give you the opportunity to employ stop loss techniques should the market turn against you as in a recession.

Your stock portfolio is part of your total asset valuation that includes savings for emergencies, real estate, bonds, and possibly precious metals. By taking this broad perspective, you have a better chance to employ overall hedges that are non-correlated to address market risk.

Asset Correlation

In Modern Portfolio Theory, the most efficient method is to create an optimal mix of asset classes that generate the highest return to risk ratio.

By owning assets that do not correlate with each other, you can reduce the risk in your portfolio. In a general sense, stocks and bonds tend to have a negative correlation. When stocks perform well, bonds do not, and when bonds perform well, stocks do not.

Market sectors have various levels of correlation. Owning sectors that are not correlated highly helps to reduce your risk. For example, stocks are closely correlated to their sector. In this case, is better for the investor to own the sector rather than the individual. Owning the sector helps to achieve some diversification, reducing the specific risk of stock ownership.

By owning asset classes that are not highly correlated, you can reduce your risk. The primary asset classes to consider are:

  • Common assets of bonds, equities, real estate, and cash
  • Geographies including the United States, European Union, the United Kingdom, Japan, China, India, Brazil and Latin America, rest of Asia, the Middle East.
  • Bond types such as Treasuries, corporate, short-term, or long-term
  • Major currencies including the US Dollar, the British Pound, the Euro, the Japanese Yen
  • Industry sectors.

When you blend asset classes that have a low correlation to each other, you are lowering the risk in your portfolio. Many investors fail to incorporate this thinking when they build their portfolios. Using the R-Squared factor, a correlation of 1 indicates the asset classes are perfectly correlated. A correlation coefficient of zero indicates there is no correlation in the performance of the asset classes.

For example, the S&P 500 and the Russell 2000 have a near-perfect correlation of 0.97. Whereas the average correlation among S&P sectors is 0.32.

Asset allocation is the most essential factor in building a high-performing portfolio. Paying attention to the risk of each asset class allows you to create a portfolio that can beat the market in good times as well as bad.

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