Risk Management and Importance of Overall Portfolio returns and diversification.

 

What is it? 

Risk Management is the process of identification, analysis and acceptance or mitigation of uncertainty in investment decisions. 

Risk is inseparable from returns in the investment world. 

Inadequate risk management can result in severe consequences e.g. subprime mortgage meltdown in 2007 that helped trigger the Great Recession stemmed from bad risk management decisions. 

How to measure risk 

A variety of tactics exist to ascertain risk; one of the most being standard deviation,  a statistical measure. (of dispersion around a central tendency).

Beta, also known as a market risk, is a measure of the vocality, or systematic risk, of an individual stock in comparison to the entire market. 

Alpha is a measure of excess return.  Managers who employ active strategies to beat the market are subject to alpha risk. 

In simple terms how much volatility (measured by standard deviation) an investor should accept depends entirely on the individual investor's tolerance for risk. 

Returns on a portfolio

In general,  the return on portfolio should be within the target range you expected, based on the investment mix you have settled upon. 

If it isn’t, you may need to make some adjustments, switching out of underperforming (relative to peers) segments of your portfolio.

The other alternative is to make changes in your future projections—for instance, 

1. you may have to increase your savings rate, 
2. you may have to take on more risk to achieve the target that you set, or
3.  you may simply have to adjust your target value downward, settling for less in the future.

Modern Financial Theory

According to Harvard Business Review - Modern financial theory rests on two assumptions: 

(1) securities markets are very competitive and efficient (that is, relevant information about the companies is quickly and universally distributed and absorbed); 

2) these markets are dominated by rational, risk-averse investors, who seek to maximize satisfaction from returns on their investments.

On a day to day basis these assumptions may not hold true.  Sometimes some of these assumptions may not even hold true for long term. 

Systematic and Unsystematic Risk 

Some of the risk investors assume is peculiar to the individual stocks in their portfolios—for example, a company’s earnings may plummet because of a wildcat strike. 
Data reveals that most times stock prices and returns move in tandem. So even investors holding widely diversified portfolios are exposed to the risk inherent in the overall performance of the stock market.
So we can divide a security’s total risk into 

1. unsystematic risk, the portion peculiar to the company that can be diversified away; and

1. systematic risk, the non-diversifiable portion that is related to the movement of the stock market and is therefore unavoidable.

(Source : Harvard Business Review)

Because of all these factors it is imperative on part of investors to 

1. Understand the risk they are willing to take on their investments. 
2. Follow a clearly laid principle of asset allocation. 
3. Follow diversification of their portfolio i.e. Do not overexpose to one share, or mutual fund scheme or bond in a portfolio.
4. Monitor their portfolio returns (overall returns) regularly and rebalance their investments.

(Disclaimer : This blog is for information purpose and not to solicit any business or provide any kind of advise)