Understanding your Portfolio's Risk and Return
by Rachna Bijlani, CFP®
July 25, 2019
Investing in stock markets can be risky. After having seen my grandfather trade commodity futures for years, I can better understand the magnitude and effects of prevelant risk and volatility in the markets. It is easy to let the lure of high returns dictate your investment choices, but I cannot emphasize enough on the importance of understanding your individual risk tolerance and aligning your investment portfolio with your risk tolerance. Sometimes, there might be disparity between an investor's ability and willingness to bear investment risk. In such cases, it is prudent to let your risk tolerance ability dictate your investment choices. Through this article, my goal is to help you better understand, in simple and concise language, the synchrony that exists between risk and return in your investment portfolio.
Assessing Risk Tolerance
Risk tolerance is a function of objective measures such as your financial goals, time horizon for each goal, liquidity needs, your tax situation and unique circumstances like your ability to save, high income, or low living expenses relative to your income. Your risk tolerance should guide your investment choices. After analyzing your income, expenses, tax situation and investment objectives, here are some sample questions that can help you further assess your risk tolerance:
How much do you have in cash reserves to cover your non-discretionary expenses?
When do you need to start withdrawing money from your investments to support your goals?
If the stock market is down 40% or more for the year, how much of your investment are you willing to lose?
If the stock market is up 20% or more for the year, how much do you expect your investments to return?
How would you describe your level of knowledge and experience with regard to investing?
In the event of a sharp decline in the value of your investments, would you panic and liquidate your portfolio?
In general, someone who is risk averse or is close to retirement, or has a low savings rate, has lesser ability to handle risk. Once you’ve assessed your risk tolerance, the next step is to understand the risk-return ratios of your portfolio as a whole.
What is risk? In simple language, risk is the uncertainty surrounding the actual return that an investment will generate. As mentioned above, your individual risk tolerance should dictate your ability to handle the level of risk in your portfolio. The two basic components of risk are Diversifiable Risk and Undiversifiable Risk.
Total Risk = Diversifiable Risk + Undiversifiable Risk
Diversifiable Risk- Diversifiable risk results from factors that are firm specific, such as the competence of firm's management, the amount of debt incurred by the firm, the success or failure of a new product, etc. It is possible to virtually eliminate diversifiable risk by holding a diversified portfolio of securities. Diversification is achieved by combining securities in a portfolio in such a way that individual securities have negative or low-positive correlation between each other’s rate of return. Diversification can lower the overall risk in your portfolio, without necessarily compromising on returns. Investors who fail to diversify are simply bearing more risk than they need to, without being rewarded for doing so. Concentrated positions in a single holding, such as your company stock acquired via medium of stock options, ESPPs or RSUs are examples of diversifiable risk.
Undiversifiable Risk- Undiversifiable risk in the inescapable risk that remains even if a portfolio is well diversified. Undiversifiable risk, or market risk, is associated with broad forces such as economic growth, inflation, interest rates, political events and changes in tax laws. Some investments are more sensitive to these forces than others and hence riskier, which is why they must potentially offer higher returns to compensate for the excess risk. Beta is the measure of this undiversifiable risk. A portfolio’s beta measures the volatility of the portfolio in relation to the volatility of the overall market or a given representative index. The beta for the overall market is equal to 1.0 and your portfolio’s beta is measured in relation to this value. If a portfolio has a beta of 1.0, the portfolio’s rate of return should be equal to that of the market. Similarly, a 0.5 beta portfolio would be considered less risky or volatile compared to the market and it's expected return would be less than the expected market return. The opposite holds true for a portfolio with beta greater than 1. This is where your risk tolerance comes into play, the beta of your portfolio should be driven by your individual risk tolerance. Once you've assessed your risk tolerance and analyzed current economic conditions and forecast of macroeconomic variables such as GDP, interest rates and inflation, the next step is to construct your investment portfolio with the optimum asset allocations, while identifying the most attractive securities within the asset classes.
Estimating Portfolio Return
The rate of return that fully compensates for an investment’s risk is called the required return. In general, riskier investments must offer higher expected returns to attract investors.
Required Rate= Risk free rate + Risk premium for your investment
The risk premium depends on how much of the asset’s risk is undiversifiable. In other words, for a well diversified portfolio, the portfolio’s beta dictates the portfolio’s required return.
Required Return = Risk free rate + [ Beta (Market return-risk free rate)]
The above formula provides a conceptual framework for evaluating and linking risk and return.
Let's take the above discussion a step further and talk about assessing your portfolio's performance. A measure called Jensen’s Alpha calculates the difference between the portfolio’s actual return and it’s required return.
Portfolio’s Alpha= Actual Portfolio Return – Required Return
A positive alpha indicates that the portfolio has managed to outperform the market on a risk-adjusted basis. For example, a diversified portfolio with an alpha of 2 would imply that the portfolio manager has generated 2% higher return than it's required rate, based on the level of risk. Negative alpha indicates that the portfolio failed to earn it's required return. As an investor, you should strive to generate the highest possible return for a given level of risk. Generating positive alpha is the holy grail of investing, and can earn a portfolio manager bragging rights.
In conclusion, I’d like to tie all the above concepts together and give you my recommended strategy for portfolio construction:
Determine your risk tolerance. Don't take on more risk than you need to take, or can afford to take.
Seek diversification by combining securities that have low correlation with each other to eliminate diversifiable risk.
Make sure that your portfolio’s beta is in line with your acceptable level of risk.
Monitor your portfolio’s alpha to keep track of your actual return versus your required return.
If all this seems a bit overwhelming and time consuming, find yourself an asset manager who can evaluate your risk tolerance, construct an optimum, well diversified portfolio based on your individual risk tolerance, and efficiently monitor your portfolio's beta and alpha. Since I’ve thrown a lot of technical information your way, I’d like to end this article on a fun and frivolous note, so here’s my rendition of Coldplay’s ‘Something just like this’ :
But she said let’s talk about your goals
How much you wanna risk?
I’m not looking for somebody
With some superhuman gifts
Some superhero, some fairytale bliss
Just someone who talk about the Beta and the Risk
I want something just like this