How do I calculate portfolio risk?

Calculating portfolio risk is an essential part of managing investments. It allows investors to understand how much risk they are taking on with their portfolio and make adjustments to meet their investment objectives. In this blog, we will walk you through the process of calculating portfolio risk and help you understand how it affects your overall investment strategy.

1. What is Portfolio Risk?

Portfolio risk refers to the possibility of losing money or not meeting your investment goals. It arises from the combination of individual asset risks and the overall market conditions. The risk in a portfolio is not simply the sum of the risks of individual assets. It is the result of how assets interact with each other, which can either increase or decrease the total risk. Investors aim to balance risk and return by carefully selecting assets and diversifying their portfolio.

2. Key Components of Portfolio Risk

There are several factors that contribute to the overall risk of your portfolio. Some of the key components of portfolio risk include:

• Market Risk: This refers to the risk that the entire market or a specific sector might experience a downturn. It is typically caused by economic factors, interest rates, or geopolitical events.
• Asset-Specific Risk: This is the risk associated with individual assets, such as a company’s financial performance, management, and market competition.
• Liquidity Risk: This is the risk of being unable to buy or sell an asset quickly without affecting its price significantly.
• Concentration Risk: This occurs when your portfolio is heavily concentrated in a single asset or sector, which can lead to higher risk.
• Interest Rate Risk: Changes in interest rates can affect the value of fixed-income investments like bonds. When interest rates rise, the value of existing bonds tends to fall.

3. How to Calculate Portfolio Risk

There are various methods for calculating portfolio risk, but one of the most common methods is to calculate the portfolio's standard deviation. This measures how much the returns of the portfolio deviate from the average return. The higher the standard deviation, the higher the risk.

To calculate portfolio risk, you need to know the following:

• Individual Asset Volatilities: These are the standard deviations of each asset in the portfolio. Volatility measures the fluctuation of the asset’s return.
• Correlation between Assets: The correlation measures how the returns of two assets move in relation to each other. If the assets are highly correlated, their returns will tend to move in the same direction. If they are negatively correlated, their returns will move in opposite directions.
• Weight of Each Asset in the Portfolio: The weight is the proportion of the total portfolio that each asset represents. It is calculated by dividing the value of an asset by the total value of the portfolio.

Here is a simplified formula to calculate the portfolio's standard deviation (risk):

Portfolio Risk (Standard Deviation) = √[ (W₁² * σ₁²) + (W₂² * σ₂²) + 2 * W₁ * W₂ * Cov(1,2) ]

Where:
W₁ and W₂ are the weights of asset 1 and asset 2
σ₁ and σ₂ are the standard deviations (volatilities) of asset 1 and asset 2
Cov(1,2) is the covariance between the two assets

4. Example of Portfolio Risk Calculation

Let’s look at a simple example to understand how portfolio risk is calculated:

Suppose you have a portfolio with two assets, A and B. The weights of asset A and asset B in the portfolio are 50% and 50%, respectively. The standard deviation of asset A is 10%, and the standard deviation of asset B is 15%. The correlation between the two assets is 0.3.

Using the formula above, you can calculate the portfolio’s standard deviation (risk) by plugging in the values. This will give you the portfolio’s overall risk, considering both individual asset risks and the correlation between them.

5. How to Manage Portfolio Risk

Once you have calculated the risk of your portfolio, you can take steps to manage it effectively. Here are some strategies to reduce or manage risk:

• Diversification: Diversifying your portfolio by investing in different asset classes, sectors, and regions helps spread risk. If one asset or sector performs poorly, others may offset the loss.
• Asset Allocation: Allocating your assets based on your risk tolerance, investment goals, and time horizon can help you balance risk and return.
• Rebalancing: Regularly rebalance your portfolio to maintain your desired asset allocation and risk level. This ensures that your portfolio stays aligned with your investment strategy.
• Hedging: Use hedging strategies such as options or futures to reduce the potential impact of market downturns on your portfolio.