The role of risk assessment in portfolio management

Before the digital era, people used to travel long distances with loads of cash in their pockets. The risks of loot and theft made these travellers keep their money safe by hiding small amounts in different places. 

Stashing cash in other parts of their baggage and pockets was a way to diversify risks and protect some money in case of a contingency. The same is done today.

Experts recommend portfolio diversification to handle risks and optimise returns, considering various risks hovering over the financial market.

Let’s learn more about the relationship between risk and return in portfolio management and key strategies for diversifying investments.

What is the Meaning of Financial Risks?

While making financial investments, investors expect some profit or return on it. Due to any reason, if one sees a reduction in the expected return instead of high returns, it is called a risk in finance.

For example, one expects a solid return if an individual invests in mutual funds or market-linked securities. However, the investment returns can drop if the market rate drops, and there is high inflation. This is known as risk.

Market risk is the risk of an investment’s value declining due to market volatility. It can also be affected by economic conditions, geopolitical events, or changes in investor sentiment.

Many methods can gauge risks. Some of the common ways are:

• Studying historical data with a standard deviation
• Measuring the volatility of the price of an asset over a period
• Understanding the nature of risk
• Managing investments and avoiding unnecessary losses.

10 Types of Investment-Related Risks

Here are different types of risks that can influence investments:

1. Market-Related Risks

A market risk occurs when an investment’s value declines due to market volatility. Other market variations that can lead to a drop in investment return value are economic conditions, geopolitical events, or changes in investor sentiment.

2. Credit Risk

Credit risk is the risk that an issuer of securities will fail to meet its obligations. Examples include making interest or principal payments.

3. Instant Liquidity Risks

Normally, this risk circulates in the real estate market. This is when you cannot instantly buy or sell an investment at a fair price.

4. Risk of Operations

This risk exists more in the industrial or business markets. It revolves around machine errors, technical failures, human errors, operational issues, etc., within an organisation.

5. Market Inflation Risk

Thisrisk affects investments that do not keep pace with the rising market prices. It can adversely affect the purchasing power of returns.

6. Foreign Exchange Risk

This risk affects those investors who put their money in foreign investments or currencies. It considers the risk of exchange rate fluctuations.

7. Risk of Fluctuations in Interest Rate

This risk impacts the value of fixed-income securities because of a sudden drop in interest rates. These fixed investments could be FDs, bonds, etc.

For example, Mr. X has invested in an FD, expecting an 8% return. However, due to changes in RBI guidelines, the return interest percentage has dropped to 7%, which can lead to losses in expected returns.

8. Concentrated Investments Risks

If one invests in one sector or asset/industry/region/market, then one may have to bear the concentration risk.

For example, if one puts their entire hard-earned money in mutual funds and, unfortunately, may have to deal with a market crash, then one’s concentrated investments can suffer massive losses.

10. Risks Related to Government or Political Changes

Your investments can be affected by the risk of losses due to modifications in government policies, changes in laws/regulations, geopolitical events, or civil unrest.

What is the Meaning of Return?

Return is the profit that investors can earn from their initial investment. Returns can come in different forms such as:

• Rental income
• Interest amount earned as return on investments
• Capital gains after the sale of assets
• Profits or dividends

There are two primary types of returns:

• Nominal Return, which includes inflation
• Real Return, excluding inflation, highlights the true purchasing power of the investment

The Relationship Between Risk and Return in Portfolio Management

Both risk and return run parallel to each other. Higher risks attract higher returns. Thus, diversifying one’s investment portfolio becomes crucial so that you can incorporate different kinds of risks and expect various types of returns.

If one’s portfolio is well-diversified, one will be able to manage various kinds of risks.

Key Factors to Consider

1. Risk can also lead to loss. It means that an investment’s actual gains may differ from expectations.
2. Return is the financial gain from an investment, and diversification helps mitigate risk. It means spreading investments across different assets.
3. Portfolio diversification helps one invest in a variety of asset classes and maintain a balance between risk and reward.
4. Identify risks associated with investments and grow wealth over time.

Preparing a Strategy for Maintaining a Balance Between Risk and Return

Portfolio diversification means investing in different kinds of securities, vital for minimising risks and maximising returns. One’s investments should depend on the following:

• Investment goals
• Risk appetite
• Time horizon

Portfolio diversification cannot eliminate the possibility of loss, but it can mitigate risk and ensure long-term financial goals.

6 Key Strategies for Effective Risk Management

Here are the top six strategies for risk management and portfolio diversification:

1. Invest in Multiple Investment Categories

Spread investments across various asset types, such as cash, stocks, bonds, mutual funds, ETFs, and other funds. Focus on assets that historically have not moved in the same direction. This way, if one part of the portfolio declines, others may continue to grow.

2. After Selecting One Type—Diversify within It

Within each investment category, select securities that vary by industry, sector, region, and market capitalisation. For example, consider a mix of growth, income, and value investments within stocks. Similarly, bonds include those with different maturities and credit ratings.

3. Diversify Considering the Risk Level

Incorporate investments with varying risk levels. Investors must not limit themselves to only high-grade, blue-chip stocks. You can balance potential losses with gains in other areas by including investments with different potential returns.

4. Rebalancing Your Assets

Investors should adjust their portfolio’s asset allocation to maintain balanced risk and return in portfolio management. For example, one investment could be doing exceptionally well compared to others. This also leads to high exposure to risks.

To rebalance the risk factor, investors can balance the returns and risks of investments by selling off the asset with maximum risk and investing in other forms with lower risk factors.

5. Hedging

It is effective to use financial instruments to reduce the risk of negative price movements in your portfolio. This is done by investing in various portfolios that can compensate for the potential losses anticipated in one investment. 

For example, if an investor has invested in stocks and expects a price fall, he can invest further in put options to compensate for some losses.

6. Risk-Adjusted Returns

Evaluate investment performance by considering the returns and the level of risk. Assess the impact of adverse market conditions or specific risk events and adjust strategies accordingly.

Conclusion

Managing risk and return in portfolio management effectively is essential for achieving financial goals. Investors must understand market risk and investment returns, assess the relationship between the two, and smartly diversify their investments to minimise risks and losses. It is critical to follow risk-adjusting strategies to protect one’s wealth and improve long-term returns.

Experts recommend guidance from financial advisors to enhance risk management efforts and deal with the complexities of portfolio management.