Quick Explainer, Portfolio Risk

Investors tend to think about risk one investment at a time. Looking at risk across all your holdings together is called portfolio risk. 

Here is our definition for portfolio risk:

Portfolio Risk: The potential for an investment portfolio to lose value or underperform. External factors can include volatility, inflation, broad market liquidity, politics, regulations, interest rates, and others. Internal factors can include portfolio concentration, shared exposure (correlation), liquidity risk, behavioral risk, and others.

Portfolio risk comes from two different sources, internal and external. External risk factors, as the name implies, act on the portfolio from the outside. Things like market moves, policy changes, and interest rate shifts will affect every portfolio, regardless of composition.

Internal risk factors are the factors that investors can influence. These are things like concentration and shared exposure that can affect your portfolio if not properly managed.

Portfolio risk can’t be measured with a single number. There are some commonly used tools that investors use to gauge their risk levels.

One is volatility*, or how much a portfolio’s value moves up and down over time. The higher the volatility, the more unpredictable the outcome of the investment. 

Another is drawdowns*. Drawdowns are how far a portfolio has fallen from the most recent peak. This gives a good picture of the downside profile. 

The third is shared exposure, measured by correlation*. Correlation is a statistical measure of how two assets move in relation to each other. Looking at correlation across a portfolio lets investors see which assets share a return profile under different market conditions. High correlation signals shared exposure and low correlation signals that assets are adding diversification. 

*Diversification does not ensure a profit or protect against loss.

These are all backward-facing measurements. They tell you how a portfolio has performed, not how it will perform moving forward.

Understanding where portfolio risk comes from is one step. The next is managing it. There are three main tools that investors can use to manage their portfolio risk. None of these will completely eliminate portfolio risk but rather can be used to shape it to fit the desired tolerance of the investor. The goal of portfolio risk management is to avoid a single event causing losses across an entire portfolio. 

Diversification is the first and primary tool investors can use to manage portfolio-level risk. Assets and investments that are driven by different economic forces tend to act differently across various market conditions. Holding uncorrelated assets can provide diversification benefits. Investors can use correlation measurements, which are historical, to understand the existing directional relationships between assets in their portfolios.

Another tool is position sizing or concentration management. Sometimes an asset grows faster over time than the rest of the portfolio. This concentration in a single asset can skew the overall risk profile and risks having the portfolio behave like that asset instead of a more diversified mix. 

The third tool is rebalancing. Rebalancing is when positions within a portfolio are adjusted to return to the intended risk profile and structure that the investor wants. This means trimming positions that have grown and/or increasing positions that have shrunk. Some investors rebalance on a strict cadence, while others do so when certain weighting triggers are hit. 

These are all ways to help shape your portfolio risk, but it is important to reinforce that they can’t remove external risk factors like broad market moves or systemic shocks. Every portfolio carries some level of those risks.

Portfolio risk is more about building and managing a portfolio where no single event can move every holding at once rather than predicting how or when the markets will take a hit. Measuring at a portfolio level, rather than an asset level, allows investors a wider view and better starting point for their desired level of risk mitigation.