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A previous post regarding asset allocation outlined three main considerations for constructing an individual’s investment portfolio: investment horizon, financial goals, and risk tolerance. While an individual’s investment horizon (timeline) and financial goals may be readily understood, risk tolerance is an often-misunderstood concept.
This post attempts to address the following questions in order to establish common verbiage when discussing portfolio risk and individual risk tolerance:
- What is risk, and what determines risk in a portfolio?
- How is risk a factor in both gains and losses in an investment portfolio?
- What’s the relationship between an individual’s risk tolerance and investment choices?
Although an individual’s investment horizon, financial goals, and risk tolerance are interconnected, risk tolerance (and aversion) often trumps the others during the construction of a portfolio. Risk is an essential element of investing, and, according to Benjamin Graham (the "father of value investing" and Warren Buffet's mentor), “the essence of investment management is the management of risks, not the management of returns."
Understanding Portfolio Risk
Q: What is risk, and what determines risk in a portfolio?
Generally, investment risk is defined as the probability of losses rather than expected profit from an investment – due to a decrease in value – such as stocks, mutual funds, bonds, etc. Risk can be further broken down, though. Total risk, which is what most investors understand to be “risk,” is the sum of systematic and nonsystematic risk.
Systematic Risk
Systematic risk, also known as “undiversifiable” risk, is market risk. Market risk, broadly, is the chance that an investor’s portfolio will decrease in value due to economic factors that impact the entire market, and is not limited to a specific company, sector, commodity, etc. Market risk, which includes equity price, interest rate, commodity, and foreign exchange rate risk, can be hedged (long put options, options collars, holding cash, short selling, etc.), but is difficult to eliminate through diversification.
Nonsystematic Risk
The other component of total risk is nonsystematic risk, which is comprised of different risks whose effects may be reduced through diversification. Nonsystematic risks are unique to particular investments or sectors – a piece of legislation or a competitor entering the market may impact a particular security’s price, but will not cause a significant change in the overall market.
Nonsystematic risks include business risk, financial risk, legislative risk, political risk, liquidity risk, regulatory risk, and strategic risk, among others. More information on investment risks and bond-specific risks from FINRA can be found by clicking on either of the links.
In an investment portfolio, each individual investment carries its own set of risks. The total amount of risk is determined by the risk and weight of each particular asset in a given portfolio. If you hold a portfolio with many investments, each of those investments carries its own risk. All of the investment risks combined result in an overall risk to which your portfolio is exposed.
Common Metrics for Measuring Portfolio Risk
Q: How is risk a factor in both gains and losses in an investment portfolio?
Now that total risk – comprised of both systematic and unsystematic risks – has been defined, how do these factors affect gains and losses in an investment portfolio? A basic way to understand to understand the answer to this question is the “risk-reward” or “risk-return” principle: investments may generate greater returns if the investor accepts a higher possibility of losses.
Higher risk within a portfolio may generate greater returns, but it may also generate greater losses. Conversely, decreasing the level of risk in an investment portfolio will typically generate lesser returns and/or losses.
There are a number of different approaches to assessing the risk present in a portfolio. Volatility is the most common stand-in for gauging risk, and is often presented in portfolio illustrations and reports. Volatility is a way of describing the degree by which share price values fluctuate. In volatile periods, share prices swing sharply up and down. In less volatile periods, prices are smoother and more predictable. Risk, specifically, is the chance of investments declining in value (note the difference).
Standard deviation (σ) provides a measure for how much a portfolio’s total return varies from its mean, and is the typical way to measure volatility. The more fluctuations – movements up and down – a portfolio return or security price makes from month-to-month, the higher its standard deviation (and, therefore, the higher its volatility).
Other common measures for risk and/or volatility include: the Sharpe ratio (which allows one to measure the risk-adjusted return of a portfolio), the Sortino ratio and Treynor ratio (both somewhat similar to the Sharpe ratio), and beta (β).
A Closer Look at Beta (β)
Beta illustrates the riskiness of an investment relative to a benchmark. The broad market has a beta of 1.0, so a portfolio with a beta of 1.0 would be expected to move in tandem (both up and down) with the market. A portfolio with a beta of 0.5 would only be expected to rise or fall 50% as much as the market. A stock with a beta of 2 would be expected to rise and fall twice as much as the market. If your portfolio has a beta of 1.2, and the market drops 10%, your portfolio would be expected to fall 12% because it is 20% more volatile than the market.
The beta of a portfolio is calculated as the weighted average of each component’s beta. A high beta portfolio indicates you may be assuming more risk than you think you are. Remember, there is not an inherent "problem" with assuming risk in a portfolio, but there is a problem with not knowing or understanding how much risk you are exposed to at any given time.
A basic understanding of these measures and relationships is helpful for investors considering different portfolio strategies or levels of risk. However, each of these measures are backward looking, and cannot definitively predict future risk or return. Despite the "past results cannot guarantee returns" disclaimer, the past is the best approximation any investor (or advisor) has, given a long enough timeline, for making informed decisions insofar as routine due diligence and monitoring are performed.
How Risk (Tolerance and Aversion) Guides Investment Choices
Q: What’s the relationship between an individual’s risk tolerance and investment choices?
Seth Klarman, hedge fund manager and proponent of value investing, put risk tolerance and investment choices like this: “The way I would think about risk aversion is most people would not want to toss a coin for their entire net worth.”
Risk tolerance, or risk aversion, is simply a gauge for how much loss an investor is willing to endure (“stomach”) within their portfolio. Risk tolerance questionnaires attempt to profile investors based on their age, net worth, liquidity needs, investment horizon, and responses to theoretical events like market swings or interest rate changes. Broadly, investors are categorized into one of three camps (although variations and in-betweens exist): conservative, moderate, or aggressive.
- Conservative: The Conservative investor prioritizes principal preservation over capital appreciation and expects lower returns in favor of liquidity and stability.
- Moderately Conservative: The Moderately Conservative investor values principal preservation, but can accept a small degree of risk and volatility. This investor requires greater liquidity, accepts lower returns, and expects minimal losses.
- Moderate: The Moderate investor balances risk reduction and enhanced returns. This investor is willing to accept modest risk to seek higher long-term returns. The Moderate investor will accept a short-term loss of principal and lower degree of liquidity in exchange for long-term capital appreciation.
- Moderate Growth: The Moderate Growth investor values higher long-term returns and is willing to accept moderate risk. This investor is comfortable with short-term gyrations and illiquidity in exchange for (long-term) appreciation.
- Moderately Aggressive: The Moderately Aggressive investor prioritizes higher long-term returns and is willing to accept significant risk and large losses. This investor believes higher long-term returns are more important than protecting principal and on-demand liquidity.
- Aggressive: The Aggressive investor values maximizing returns and will accept substantial risk, volatility, significant (unrealized) losses, and illiquidity. This investor favors maximizing long-term returns over protecting principal.
Final Thoughts on Risk and Risk Management
Investment selections within a portfolio are often defined within the context of an investor’s risk profile insofar as the financial goals and investment horizon constraints are also considered. An appropriate allocation of management styles – tactical, strategic, and dynamic, for example – and asset types combine to form a portfolio in line with each individual’s goals, liquidity requirements, timeline, and risk profile.
Tolerance for risk is an individual choice – it’s the responsibility of our team at RP Wealth Advisors to understand each client’s attitude and financial profile in order to make appropriate recommendations regarding investment strategies. We utilize various measurement tools and technologies, including deep-dives on current and proposed portfolios, in order to look at risk from both a granular and general point-of-view. Additionally, our team seeks to generate alpha (greater returns) by mitigating some of the behavioral mistakes often committed by individual investors during volatile ("high-risk") market periods. In helping our clients understand and mitigate risk, when applicable, the RP Wealth Advisors team not only helps our clients build their financial literacy, but build toward their future financial goals, as well.
All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy referenced here will be successful. The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by RP Wealth Advisors to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Diversification and asset allocation are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss.