Portfolio risk

Definition

Portfolio risk refers to the potential financial loss associated with the collection of investments held by an individual or institution. It encompasses both the risk of individual assets and the overall risk of the entire portfolio, influenced by the correlation between different asset returns. A well-diversified portfolio can mitigate specific risks, but systematic risks remain that affect the broader market.

5 Must Know Facts For Your Next Test

1. Portfolio risk is measured using statistical methods, particularly variance and standard deviation, which assess the volatility of returns.
2. Investors can reduce portfolio risk through diversification, which helps to offset losses in some assets with gains in others.
3. While diversification can significantly lower specific risk, it cannot eliminate systematic risk, which is affected by economic factors that impact all investments.
4. Correlation between assets is crucial in determining overall portfolio risk; assets with low or negative correlation can effectively lower overall volatility.
5. Effective portfolio management involves continuously monitoring and adjusting asset allocation to align with changes in market conditions and investment goals.

Review Questions

• How does diversification help in managing portfolio risk?
  • Diversification helps manage portfolio risk by spreading investments across different asset classes, sectors, or geographical regions. This reduces the impact of poor performance in any single investment, as losses in one area can be offset by gains in another. A well-diversified portfolio minimizes specific risks while potentially enhancing returns, making it a fundamental strategy for investors aiming to achieve a more stable performance over time.
• What is the difference between systematic and specific risk in the context of portfolio risk?
  • Systematic risk refers to market-wide risks that affect all investments, such as economic downturns or changes in interest rates, while specific risk pertains to risks unique to individual investments. Portfolio risk management must address both types of risk; diversification can mitigate specific risks but cannot eliminate systematic risks. Understanding this distinction helps investors make informed decisions about how to balance their portfolios.
• Evaluate the impact of asset allocation on portfolio risk and investment outcomes.
  • Asset allocation significantly influences portfolio risk and investment outcomes by determining how capital is distributed among various asset classes. A strategic allocation can optimize returns relative to the level of acceptable risk, aligning with an investor's financial goals and time horizon. By carefully selecting the mix of assets—such as equities, fixed income, and alternatives—investors can manage exposure to both systematic and specific risks, thereby enhancing long-term performance and stability in their portfolios.

Related terms

Diversification:

The investment strategy of spreading investments across various assets to reduce exposure to any single asset or risk.

Systematic Risk: The risk inherent to the entire market or market segment, which cannot be mitigated through diversification.

Asset Allocation: The process of dividing investments among different categories, such as stocks, bonds, and cash, to manage risk and achieve desired returns.