Portfolio risk

Definition

Portfolio risk refers to the potential for loss in value of an investment portfolio due to the uncertainty in returns. This risk is influenced by various factors, including market volatility and the correlation between different assets in the portfolio. Understanding portfolio risk is essential for making informed investment decisions and optimizing returns while managing potential losses.

5 Must Know Facts For Your Next Test

1. Portfolio risk is not just about individual asset risks but also how those assets interact with one another in terms of correlations.
2. A well-diversified portfolio can significantly reduce unsystematic risk, but systematic risk remains present regardless of diversification.
3. Investors use measures such as standard deviation and beta to assess portfolio risk and understand how much volatility they might experience.
4. Modern Portfolio Theory suggests that investors can achieve the best possible return for a given level of risk by carefully choosing a mix of assets.
5. An increase in the correlation between assets typically leads to higher overall portfolio risk, as it means that assets may move together in value more closely.

Review Questions

• How does diversification impact portfolio risk, and why is it an important strategy for investors?
  • Diversification impacts portfolio risk by spreading investments across various assets, which helps reduce exposure to any single asset's poor performance. By holding a diverse mix of stocks, bonds, and other asset classes, investors can lower their overall risk profile while still aiming for acceptable returns. This strategy is vital because it mitigates unsystematic risk, allowing for better protection against unexpected events affecting specific investments.
• Evaluate the role of systematic and unsystematic risks in determining the overall portfolio risk. How do these types of risks differ?
  • Systematic risk affects the entire market or a specific sector and cannot be eliminated through diversification, making it a fundamental component of portfolio risk. In contrast, unsystematic risk is unique to individual assets or industries and can be mitigated by diversifying investments. Understanding the balance between these two types of risks helps investors make strategic decisions about asset allocation and how much exposure they want to particular sectors versus the market as a whole.
• Synthesize how Modern Portfolio Theory uses the concept of portfolio risk to optimize investment strategies for various investors.
  • Modern Portfolio Theory (MPT) utilizes the concept of portfolio risk to help investors maximize expected returns for a given level of risk through an optimal asset allocation strategy. By analyzing the relationships between different assets' returns and their correlations, MPT guides investors in constructing a diversified portfolio that balances risk and reward. This approach recognizes that not all risks are equal and emphasizes finding the right mix of assets to achieve financial goals while maintaining an acceptable level of volatility.

Related terms

Diversification:

A risk management strategy that involves spreading investments across various assets to reduce exposure to any single asset's performance.

Systematic Risk: The inherent risk that affects the entire market or a segment of the market, which cannot be eliminated through diversification.

Unsystematic Risk: The risk associated with a specific company or industry, which can be reduced through diversification.