Portfolio risk
A portfolio represents a combination of financial assets like bonds, cash equivalents, stocks including closed fund and mutual exchange equivalents. Although portfolios are in the hands of investors, they are managed by professionals operating within the financial sector. This professional management originates from the idea that in a risky situation, a mix of assets, projects or diverse portfolios will fail to live up to the required profitability which is the general objective of a portfolio. This below-par performance of portfolios might be attributed to the poor portfolio risk balance in a business environment. Therefore, portfolio risk is the likelihood of an investment portfolio not achieving its intended objective of profitability (Investopedia, 2014).
Investors need to build an investment portfolio considering their investment objectives and the risk tolerance of a given enterprise. For example, stocks with large ceiling value, broad in terms of market index funds, higher cash equivalents might be preferred by conservative investors. However, a small ceiling on stock growth, high risk and yielding exposures and stocks with large growth are preferred by risk lovers who are considering an alternative investment portfolio (Investopedia, 2014).
Historical development of Portfolio Risk
The portfolio is an assortment of revenue-producing assets necessary in meeting the financial goal of profitability for an enterprise. The history of the portfolio dates back 7 decades. In the 1930s, people held portfolios but had different perceptions about them. However, in 1938, the theory of investment capturing the thinking of that time was developed. This was necessitated by the fact that portfolio information was limited and prices failed to convey cored information. This continued until 1960 when the focus finally changed to risk thereby marking the beginning of the modern portfolio risk analysis.
A portfolio risk can result from systematic risk factors which encompass interest rates, economic recession, and political instability and war risks. This risk factor is irregular, has significant implication on a company’s share prices and is hard to be eliminated completely from investment. For example, trends in interest rate can be determined in the long run but the future variations in amounts are difficult to estimate. Secondly, portfolio risk can result from unsystematic or specific risk factors. These relates to risks of owning shares in a given firm in a portfolio. For example, by raising the number of firms in a given portfolio, risk is being spread which in turn reduces the impact on non performing sticks.
Calculating portfolio return and risk
During portfolio return estimation, specific assets and relative weights are taken into account. Therefore, a return from portfolio shows the weighted average of returns from assets and should add up to 1.
where Rp represent portfolio return; R1 is the weight of specific asset; W1 is the return from specific asset as a percentage (Finance train, 2014).
However, a portfolio risk can be determined using standard deviation and correlation between assets (Finance train, 2014).
Uses of portfolio risk in financial decision making
First, portfolio risk analysis enhances the process of financial asset measurement in a market. In this way, it acts as a futuristic tool in predicting the volatility of a financial instrument (Madhavan & Young, 2003). Secondly, portfolio risk analysis promotes an investor’s level of risk exposures thereby necessitating optimal portfolio development. Thirdly, risk analysis acts as a guide for the evaluation of past performance. For instance, risk analysis supports the evaluation of actual returns contrasted to risks involved in achieving those returns (Madhavan & Young, 2003). In addition, risk analysis has the potential of revealing changes in future stock returns. In addition, they allow for meaningful benchmarking and hedging by investors by separating risk into alternative sources and assessing their performance in terms of portfolio returns and risks incurred in their creation (Madhavan & Young, 2003).
References
Finance train. (2014). How to calculate the portfolio risk and return. Web.
Investopedia. (2014). Definition of the portfolio. Web.
Madhavan, A. & Yang, J. (2003). Practical risk analysis for portfolio managers and traders. Web.