Assessing Portfolio Risk
October 27, 2020
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Most investors know that they should evaluate their risk tolerance when considering an investment. Often, they think of risk only in terms of the possibility of losing money. However, risk is defined as the probability that an investment's actual return will be different from its expected return. Making or losing money can be affected by numerous factors, and total risk is a measure of variation in return due to all risk sources.
Risk tolerance goes hand in hand with our time horizon. If you have 7, 8, 10, 15, or more years to invest before your retirement, you may be able to have a more aggressive profile. This allows you to invest more in the equity sector, which is considered a higher risk instrument. Remember to keep in mind your expectations and how much time you have before your retirement. History shows that fluctuations will occur in the market. But the expectation remains on that you end up with more money than what you initially invested.
General Risk
General risk refers to factors outside individual companies that affect an entire asset class or the market as a whole. One type of general risk, known as market risk, may be a function of political, economic, and sociological events or changes in investor preferences. For example, market risk occurs when the overall business climate changes, bringing expectations of lower corporate profits, and causing stock prices to fall in general.
A second factor that may broadly affect all companies is interest rate risk—the fluctuations in the general level of interest rates. The bond market is particularly sensitive this type of risk given that bond prices tend to move in the opposite direction of interest rates. Although bonds are generally the most affected by this risk, other investment vehicles may be impacted as well. Companies that borrow heavily to finance their operations may see their stock prices affected by changes in borrowing costs.
A third general risk factor is the impact of inflation, defined as a general rise in the price of goods and services. Inflation risk is the inability of a particular investment to keep pace with the increase in prices. For example, if an investment returns 3% annually, but inflation averages 4% annually, the investor will be losing purchasing power by holding the investment. Purchasing power risk is generally highest in products paying relatively low fixed-interest rates, such as savings accounts.
Specific Risk
In contrast, specific risk is that portion of total risk that is unique to a firm or industry. Specific risk is typically subdivided into business risk and financial risk.
- Business risk is associated with the nature of the enterprise or industry itself. It measures the company’s ability to meet obligations, remain a profitable entity, and provide acceptable returns to investors. It is generally believed that similar firms have comparable business risk. However, differences in management, operating costs, and market opportunities can create diverse levels of business risk.
- Financial risk measures a company’s mix of debt and equity used to finance its operations. Debt creates principal and interest payments that must be paid before earnings are distributed through dividends to stockholders. The larger the proportion of debt, the greater the financial risk.
