What is portfolio risk? Portfolio risk is a term that defines the potential value loss in an investment portfolio. This can happen due to several factors which include market volatility, interest rate changes, and currency fluctuations amongst others.
Portfolio risk management involves the collection and analysis of these risks. Through this investors can make more informed decisions to upgrade their portfolio strategy. While assessing the risks is important, as an investor, understanding the types of risks in portfolio management is equally important.
Each of these risks threatens the validity and strength of your portfolio by making your investments weak. It means you made some bad investments. So, let’s see how you can identify them to avoid them.
9 Types of Risk in Portfolio Management
In the world of portfolio management, there are certain risks that you might encounter. Such risks are common but avoidable. If you are aware of the nature of the risks, then you can come up with strategies to avoid them. So, let’s look at the types of risk in portfolio management.
- Market Risk
Upon entering the market, you’ll encounter various risks, notably the market risk. This particular risk, listed among the types of risks in portfolio management, is a systematic risk. Owing to its name, you can guess that it arises due to the prevailing volatile situation in the market.
Since the market is volatile, the risks there are prevalent and cast a dark shadow over your investments. It also can make a bad investment which will reflect on your portfolio making it “look bad”.
- Equity Risk
This risk stems from the fluctuation in stock prices. It results in the unsettling prospect of losing capital if there is a stock market decline. Investments that are heavily reliant on the stock market rise and fall with it. There is a chance of potential financial erosion in the event of huge losses.
- Interest Rate Risk
The third type on this list of types of risk in portfolio management is interest rate risk. This arises when there is a sudden change in the interest rate. If there is any investment type that poses the most risks with the changes in the interest rate, it is the debt investment. This might happen as alterations in the interest rate might result in heavy losses, but they might also bring in gains.
- Currency Risk
This is about the risk of loss due to variations in the foreign exchange rates. A shift in the exchange rate can diminish returns when you convert them back to your currency.
- Liquidity Risk
There is another type of risk that arises in portfolio management. It s liquidity risk. This poses a threat to your finances, as it does not allow you to sell an investment quickly without incurring a substantial loss in value.
Liquidity risks arise only in emergencies when you promptly need cash. However, liquidating your assets in such a case does not hold much value as the market value is low.
- Concentration Risk
This is the next one on our list of types of risk in portfolio management when investors heavily invest in one type of asset. Time and again, you have heard the importance of diversifying your assets. If you are an investor who diversifies their assets, you are less likely to face this problem.
Diversification across different asset types helps you mitigate risk and losses. You can also disburse your assets in a manner that helps you avoid multiple risks at once. Take advantage of the expertise of a portfolio manager, as you know where to invest to maximise your gains.
- Credit Risk
If you are thinking of the types of risk in portfolio management you need to ensure the safety of the money, then credit risk has the answer for you. This type of risk arises when your money’s safety is in jeopardy.
Let’s say the company or the project that issued the bonds is not performing well financially. There is also a chance you might not get your investment back. Therefore, it’s a good idea to check the credit rating of the bonds before you invest in them.
- Reinvestment Risk
This concept of investment risk plays with the interest you receive on the invested amount. Imagine investing your money in a bond that pays you a nice amount of interest.
But if interest rates in the market go down, you might not find another good investment that pays the same amount. Your future returns may not be as good as before.
One of the sources of risk in investments is callable bonds. You can redeem them when the interest rates decline. Therefore, you need to choose the right type of investment and company to ensure growth.
- Horizon Risk
The last one on the list of types of risk in portfolio management is about unexpected events that might force you to sell your investments at a bad time. For example, you planned to keep your money invested for many years, but something comes up, and you have to sell when the market is not doing well. This can lead to losses.
However, as an investor, you may not have to encounter such risks by reducing their probability. The key is to have in place strategies that will prevent the possibility of reduction. Remember, it cannot negate them, as the market is unpredictable and volatile.
3 Strategies to Mitigate Risks
- Establish a Maximum Loss Plan
The portfolio team is responsible for managing the features of portfolio management. The team ensures that you do not lose any part of your portfolio when risk occurs. That is where the maximum loss plan comes into the picture. A market with prolonged price declines can result in destroyed portfolios.
Having a maximum loss plan makes you invest more conservatively. It ensures that valuation is a major concern in your asset allocation. It is best use an adaptive asset allocation for portfolio risk management.
- Implementing Tactical Asset Allocation
90% of investment returns are due to portfolio asset allocation. Through investment allocation, you can divide the amount you invest into different groups and companies. A tactical asset allocation helps investors came up with a dynamic strategy that focuses on the objectives of portfolio management.
Learn more about how to manage risks in our blog- How to Manage Risk in Mutual Funds?
You would want to allocate more to assets whose prices are far below their real value. In long-term returns, the valuations are high. So to avoid all such types of risk in portfolio management, it is best to allocate your assets tactfully into various investments.
- Active and Passive Management
There are two strategies that you can adopt to mitigate the possibility of any type of risk in portfolio management occurring. That is active and passive management of your portfolio. Active management is a strategy that allows you to make investment decisions depending on market conditions and security analysis. This strategy is popular amongst professional investors who have the time and resources to analyse security.
Passive management, on the other hand, means you put your money in a collection of investments that copy a stock market index. People like this approach because it’s cheap and doesn’t need much attention.
FAQs:9 Types of Risks in Portfolio Management: How to Identify and Avoid Them
How do you measure portfolio risk?
The Value at Risk (VaR) method is a simple way to measure the risk of a renewable energy investment portfolio. VaR measures the maximum loss and quantities based on calculations over some time. Investors can see the worst-case scenarios. For instance, if the VaR is 5%, then it means the investor (you) stands a chance of losing 5% of the entire investment in any given month.
What are some portfolio risk measurement strategies?
Some common risk measures include beta, standard deviation, tracking, error, and drawdowns. A few of the strategies include diversification, hedging, asset allocation, and using a risk budget.
How can I mitigate operational risks in my renewable energy portfolio?
Diversifying your portfolio is one way to mitigate operational risks in your renewable energy investment portfolio. It increases the resilience of the portfolio and protects cash flows and profits from market volatility.
Is diversification a reliable strategy for risk management in solar power investments?
Asset diversification is necessary, as it not only spreads investments but also mitigates risks. A portfolio manager will ensure that your portfolio covers different sectors and asset types. Consider the risk-return profile of each investment for a balance between risk tolerance and financial goals.
How can Sustvest help with my portfolio risk management?
Through Sustvest, you can diversify your portfolio by investing in various sectors. It reduces the risk of your concurrent financial losses when the market is volatile. Sustevest’s financial experts will help with your investment allocation.
Knowing everything about the types of risk in portfolio management, choose the best options to diversify your portfolio. Always select the ones that will bring in profits while growing your portfolio. Assess the market risks before investing.
While there are risks involved, you still minimise them with the expert advice of your portfolio manager. Let your manager devise strategies for you that will not only mitigate such risks but also grow your investments and portfolio thus giving you a stronger footing in the renewable energy asset investment market.
With Sustvest, you can confidently start your investing journey in the renewable energy sector for “green” financial returns and profits on your investments.
Founder of Sustvest
Hardik completed his B.Tech from BITS Pilani. Keeping the current global scenario, the growth of renewable energy in mind, and people looking for investment opportunities in mind he founded SustVest ( formerly, Solar Grid X ) in 2018. This venture led him to achieve the ‘Emerging Fintech Talent of the Year in MENA region ‘ in October 2019.