Ask any investment manager about their key focus areas while managing portfolios and you’re likely to hear risk management as one of the top 3. There are risks in doing pretty much most things in real life and the same applies to the financial world as well. There are risks in keeping money in a bank, in a passive or active investment vehicle and there are even risks in investing in the safest of government-backed treasury bills, however, the nature of risks in each is different. We shall look at some of the key aspects of portfolio risk in this and the next few notes.
Put simply, portfolio risk is the chance that a portfolio of assets does not meet the financial goals which it was set to achieve. For e.g., if the financial goal is capital preservation, then the risk for this portfolio would be if it were to lose value. Similarly, if the goal is to grow wealth in real terms, then the risk would be if the portfolio were unable to beat the rate of inflation. While there could be other risks such as operational, tax, regulatory or sovereign risk, for the context of this note we shall only be focusing on the financial risks inherent to the portfolios.
While some forms of risk are common across all portfolios, each individual asset or financial product comes with its own set of risks. A portfolio of stocks has a very different set of risks when compared to real assets such as gold or real estate, therefore it is imperative to understand the nature of the underlying securities or products and evaluate risks which are most relevant to those. In this section, we shall look at some common forms of risk, some of which will be specific to certain assets or products, while some might be more generic in nature.
Market risk: Probably the most common one, which basically is the risk to the portfolio from a drop in prices of the underlying market or asset class. For a portfolio of stocks, this could be a fall in equity markets; for a portfolio of long-maturity bonds, this could be due to a rise in interest rates and for real estate, this could be due to poor macroeconomic conditions. This is something that cannot be eliminated but can be greatly reduced by asset class diversification.
Interest rate risk: This is one of the largest risks for portfolios that are heavily tilted towards debt or other yield-bearing assets. A rise in interest rates would make the prices of most such instruments fall, although the sensitivity of the portfolio to such a rise would depend on the ‘duration’ of the portfolio- longer maturity assets would be impacted a lot more than shorter maturity ones. While the impact on debt instruments is direct, this might also have an indirect effect on seemingly uncorrelated assets such as equity or credit, as the underlying cost of capital would increase for all businesses and rate-sensitive businesses would get impacted a lot.
Currency risk: Applicable primarily to investments in a different currency, this is the risk of the investment currency depreciating with respect to the investor’s primary currency. For e.g., a US-based investor might diversify their holdings across various countries and if the value of their respective currencies depreciates significantly against the US dollar, it would represent a significant drag on returns, even if the underlying portfolio does well in local currency terms.
Credit risk: Also known as default risk, typically relevant to debt products and securities, is the risk of the issuer or borrower being unable to repay the investment amount in full. While the nature of this is apparent for bonds, credit risk might occur in some financial products in different ways, especially if the issuer or the investment manager goes out of business.
Liquidity risk: Liquidity, or the lack of it, is easy to ignore during normal times, but can really exacerbate other risks or become the biggest risk during times of stress. It is the risk of not being able to sell part or all of your holdings in a portfolio. Some asset classes, such as real estate or unlisted equity, are illiquid by nature while there exist illiquid/less liquid securities within listed asset classes like equity and debt. Also, there could be a stark difference in liquidity profile between the investment vehicle and its underlying holdings, and this could be a hidden risk especially if the underlying portfolio is a lot less liquid than the investment vehicle; for e.g., a small cap mutual fund might offer daily liquidity, but the underlying stocks are unlikely to be as liquid, especially if there are large redemptions.
Concentration risk: The opposite of diversification is the risk of having a high percentage of a portfolio in a single asset class or assets with common return drivers. This could be at the asset class level, such as portfolios concentrated in equities, debt, or real assets or they could be within an asset class such as equity portfolios concentrated in small-cap stocks or debt portfolios holding only high-yield debt.
While the above list presents the most well-known risks inherent in common portfolios, this list is by no means exhaustive. In the next post, we shall take a look at some of the lesser-known risks and explain the context in which they might be relevant.