Investment is a complex game that involves offense and defense as well. Many investors who are good at the offensive game with aggressive investment strategies may get surprised and disappointed in seeing their portfolios in deep red, especially during a depression or during a recessionary period.
Financial risk management involves the defensive strategies one should adopt to tide over unexpected difficult phases and to minimize the investment losses.
Risk is inherent to all investments but the degree of risk involved varies between them. And naturally, investing in a single of a few channels can be suicidal as entire wealth can be wiped off if something adverse happens.
So let’s look at some of the smart strategies we can adopt to maximize our return and reduce the risk involved.
Table of Contents
Portfolio and Investment Risks.
A portfolio can be defined as any combination or group of financial assets, such as stocks, bonds, gold, commodities, currencies, and their cash equivalents as well as their fund counterparts. They may include mutual funds or exchange-traded funds and closed funds also.
A portfolio can also consist of non- tradable investments like real estate and private investments.
How to create a good portfolio
Goals and Risk Tolerence
Determining short term and long term goals are the foundation stone of every successful portfolio. Goals vary widely based on your needs and financial aspirations.
Generally speaking, risk tolerance changes widely based on the age of the investor. If you are young, naturally you have more time to recover even if your investment decision failed.
Picking assets for your portfolio
An efficient portfolio comprises of a variety of asset classes like bonds, stocks, real estate, gold, and even private investments. The more diversified your portfolio, the less risky your investments are.
You have to diversify your investments between different asset classes which have a negative correlation with each other like stocks and bonds, or you can even add investments like real estate or hedge funds to reduce your risk profile.
How does diversification work?
Let us consider an example, a man who sells ice creams when the weather is nice. But he could sell umbrellas to compensate for the loss of his business during rainy days thereby he reduces his risk of losses. The same principle is applied in portfolios to minimize risk and maximize returns.
The idea here is that putting your eggs in different baskets reduces your risk compared to putting all your eggs in one basket.
Let’s take an example, suppose we have 2 firms A and B where A produces ice-creams and B produces umbrellas. If we invest in both of them in 50:50 proportion then you will have less risk than investing in the least risky asset.
Let’s see how that happens…
|Criteria||Ice Cream||Umbrella||50:50 Allocation|
|Performance (in %)||23.0||-26.0||-1,5|
|Downside Volatility (in %)||17.2||8.4||5.2|
(downside volatility represents the risk of the investment)
ie, the 50:50 portfolio is less risky than the least risky of these firms, which is the umbrella firm. When you diversify you end up with a portfolio that is less risky than the least risky asset and that’s the magic of diversification.
An efficient investor tries to minimize his risk and get the maximum return out of his portfolio.
Diversification within same asset class
In Stocks, diversification can be achieved effectively by investing in sectors with a negative correlation. For example, IT and real-estate sectors. By spreading the risk, such investments bring down your risk.
Remember that what matters is the overall performance of your portfolio and not the performance of an individual asset or stock. So diversification is a very important aspect you must take care of. In short, an optimal portfolio is a well-diversified portfolio.
Watch out the Beta
The beta is a measure that determines the risk of your investments, particularly applicable for stocks. The Beta is a measure of the volatility(risk) in relation to the overall market.
If a stock moves less compared to the market fluctuation, the stock’s beta will be less than ‘1’.
If the beta value is more than ‘1’ that means the stock moves more than the market fluctuation limits in a given period. High-beta stocks are supposed to be riskier but they also have the potential for providing good returns.
Stocks that have a beta of ‘1’ tend to move with the market and have a neutral risk. The beta of your portfolio can be calculated if you know the percentage of your portfolio by individual stock and the beta of each of these stocks.
Covariance, correlation, and Risk
Covariance is nothing but a measure of correlation. On the contrary, correlation refers to the scaled form of covariance. Correlation is dimensionless, i.e. it is a unit-free measure of the relationship between variables.
Covariance is a statistical measure of how two assets move in relation to each other. A negative covariance indicates that the price of two assets moves in opposite directions.
In the construction of a portfolio, it is good to attempt to reduce the overall risk and volatility while striving for a positive rate of return in the long run.
Gold and Stocks have proven over time to have a negative covariance. Investing in both of them together will bring in more stability.
Efficient Portfolio Frontier
The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk. Portfolios that lie below the efficient frontier are sub-optimal because they do not provide enough return for the level of risk it bears.
Covariance and Modern Portfolio Theory(MPT)
Modern portfolio theory (MPT) is developed based on the covariance of different investment commodities. This theory attempts to determine an efficient frontier for a mix of assets in a portfolio. Modern Portfolio Theory seeks to create an optimal mix of higher-volatility assets with lower volatility assets. By diversifying the assets in a portfolio, investors can reduce the risk and still allow for a positive return.
The Modern Portfolio Theory introduced by economist Harry Markovitz in 1952, is a formalization and extension of diversification in investing. The key takeaway is that owning different kinds of financial assets is less risky than investing in one type.
Risk aversion and age
A risk-averse investor prefers lower returns with known risks rather than higher returns with unknown risks. In other words, among various investments giving the same return with different levels of risks, this investor prefers the mode of returns with the least risk.
Generally speaking, the younger you are, the riskier your investment portfolio can be. The reason being, that the younger a person is, the more time they have to recover and recoup any losses from things like a sudden market downturn. Someone who’s a few years away from retirement, however, won’t have the necessary time to recover from a plunge in the markets.
Designing a portfolio with proper attention to goals and understanding your risk appetite is the key to a successful investment strategy. Diversification and balancing the risk will help you to tide over unexpected difficult investment phases.