Portfolio Risk Management: How to Measure and Manage Portfolio Risk

Whenever you invest your money in the market, a certain level of risk naturally comes with it. Your investments may lose value, your returns may fall short of your expectations, you may not be able to withdraw funds when you need them most, inflation may erode your long-term wealth, or in rare cases, an asset may even default. 

It may all sound like a valley of danger, but you do not need to panic. Investing does not require worry. It requires awareness and caution. When you understand the different types of risks and how to manage them, you can control your financial future to a great extent.

This article will walk you through the concept of measurement of portfolio risk and return, and more importantly, how to manage these risks effectively to build a solid portfolio. 

What is portfolio risk?

Portfolio risk refers to anything that can go wrong or work against your expectations when you invest your money. It is the possibility that your returns may fall short, or that the value of your investments may fluctuate more than you are comfortable with. When your portfolio keeps swinging up and down or delivers unstable returns, it may be carrying more risk. Portfolio risk can create worry, stress, and panic. At times, it can even push you to make hasty decisions driven by fear rather than logic, especially during market volatility. 

Your portfolio carries different types of risks, depending on what you have invested in. Inflation risk is one example in which rising prices can lower your purchasing power. Liquidity risk comes up when you cannot easily convert your investment to cash without incurring penalties or taking a loss. If you own bonds, you may face credit risk, which is the possibility that the issuer may default. Asset class risk makes certain investments riskier. For instance, stocks can be more volatile than bonds.

Your responsibility as an investor is twofold. First, you need to understand how to calculate portfolio risk, and second, you must use the right strategies to manage or reduce it. Once you are aware of where your risk is coming from, it becomes much easier to adjust your asset allocation, rebalance your investments, and focus on your long-term goals.

How do you measure risk and return?

Portfolio risk can be measured in different ways. There are several parameters that can help you estimate risk and how it may interfere with your returns. Let’s discuss some of the most popularly used ones:

1. Sharpe ratio

Named after Nobel Laureate William F. Sharpe, the Sharpe ratio is a simple measure that helps you understand the returns you earn relative to the risk you take. The Sharpe ratio tells you how much extra return you are getting for every unit of risk you take on. So, if you are comparing two funds, two stocks, or even two complete portfolios, the Sharpe ratio gives you a clearer idea of which one offers the better balance of reward and volatility.

The formula itself is straightforward:

Sharpe ratio = (Rp – Rf) ÷ Standard deviation

Here’s what each part means: 

• Rp is the return of the investment you are analyzing, such as a historical return or an expected one.
• Rf is the risk-free rate. Most investors use the yield on a U.S. Treasury bill.
• The final part, standard deviation, measures how much the investment’s returns vary over time. The bigger the difference, the higher the standard deviation, and the more risk you are taking.

What makes the Sharpe ratio so useful is how it simplifies comparison. A higher Sharpe ratio generally indicates that you are getting more return for the level of risk taken. A lower Sharpe ratio suggests the opposite. Two investments can both give you the same return, but the one with less volatility will usually have the better Sharpe ratio.  

A Sharpe ratio between 0.0 and 0.99 is considered low. This usually suggests that you are taking on a fair bit of risk without getting much reward in return. A ratio between 1.00 and 1.99 is generally viewed as good. A ratio between 2.0 and 2.99 is very good. And, anything between 3.0 and 3.99 is outstanding. If the Sharpe ratio slips below 0, you should be cautious. This is a negative ratio and implies that the investment is delivering a return lower while still being volatile. 

There are a few things you should keep in mind, though. The Sharpe ratio assumes past volatility will resemble future volatility, which is not always true. Despite its limitations, the Sharpe ratio remains one of the most popular tools for measuring portfolio risk and return.

2. Alpha

Alpha measures how well an investment performs compared to the overall market or a specific benchmark index. It is a commonly used measurement of portfolio risk when evaluating actively managed mutual funds or Exchange-Traded Funds (ETFs). Here’s how it works in simple terms: 

Every fund or investment is usually compared to a benchmark. For many U.S. stock funds, the S&P 500 is the go-to comparison point. If the S&P 500 delivers a certain return, you would expect a fund tracking similar types of stocks to also offer similar profits.

Alpha tells you whether the fund did better or worse than the benchmark index. For instance, let’s say your fund returned 13% in a given year. During that same period, the S&P 500 returned 10%. In this case, the alpha is 3%. So, your fund has outperformed the market by 3% points. If the fund had returned 8% instead, its alpha would be –2%, implying it underperformed the market.

A positive alpha is ideal, as it suggests the fund has outperformed the market after accounting for the risk it takes on. A negative alpha tells you the opposite. In this case, the fund has underperformed. 

3. Beta

Beta measures how much a stock’s price moves compared to the overall market. The market always has a beta of 1, so this number becomes your reference point. If a stock has a beta above 1, it tends to be more volatile than the market. If it has a beta below 1, it is generally more stable.

The calculation of beta itself is perhaps the simplest in concept because you only need to look at one number, which is the beta. This single digit tells you everything you need to understand the stock’s relative volatility. There is also a formula behind it, if you wish to calculate it on your own manually:

Beta = Covariance (Stock Returns, Market Returns) / Market Variance, but most investors do not need to calculate it manually.

In practice, beta tells you what to expect:

• A stock that is more volatile over time will have a beta greater than 1.0.
• A stock with lower volatility will have a beta below 1.0.

High-beta stocks carry more risk but also offer the potential for higher returns. Low-beta stocks tend to be steadier and deliver lower, but more stable, returns. So, whether you want to reduce risk or add more growth-oriented exposure, beta can help you make a choice.

Everything you need to know about portfolio and risk management

Measuring portfolio risk and return is only the first step. What truly matters is what you do with that information. Once you understand where your portfolio stands, the next task is to manage risk and enhance returns. Here’s how you can approach this:

1. Start with careful selection

Your investment choices should always align with your goals, age, and time horizon. These factors help define the level of risk your portfolio can comfortably carry. For instance, if you are young, you generally have a longer time horizon and can afford to take on more risk. In that case, holding a higher proportion of stocks makes sense. Within stocks, you might even include more high-beta stocks because you can withstand the volatility in exchange for higher growth potential. If you are risk-averse, stocks may not always feel right, and if you do include them, choosing low-beta stocks can help keep volatility under control. 

You can use alpha in a similar way when choosing between mutual funds and ETFs. Alpha helps you understand how well a fund performs compared to its benchmark. A fund with a higher alpha indicates better risk-adjusted performance, and vice versa. You can use these metrics or consult with a financial advisor to understand how these metrics can be used when creating your portfolio. 

2. Exercise caution and understand the risks each asset carries

Every asset comes with its own set of risks, and the key is figuring out which ones you are comfortable living with. Take stocks, for example. They are inherently risky. This is not news to anyone. Their prices move up and down, and you need to be genuinely okay with that before investing. If you are unsure how much volatility you can handle, a financial advisor can help you evaluate this more clearly.

Real estate comes with a very different problem – liquidity. Property can be difficult to sell quickly, so you need to accept the fact that your money might be locked in for a while. Bonds issued by borrowers with weaker credit carry credit risk. This refers to the possibility that the issuer may struggle to pay back what they owe. And even cash, which feels like the safest option, carries inflation risk because its value slowly erodes over time. 

These are broad truths about each asset class, and they do not change much. That is why it is important to exercise caution before diving into any investment. Make sure the risk you are taking is one you understand, can tolerate, and still aligns with your financial goals.  

3. Diversify your portfolio as per your financial goals

While risk is petrifying, it is also necessary for growing your wealth. The link between risk and reward has always been straightforward – the higher the risk, the greater the potential for returns. The essential thing is to make sure you take calculated risks. One of the best ways to keep risk in check is through diversification. When you spread your investments across different assets, you give yourself a cushion. If one part of your portfolio struggles, the others can help balance things out.

A good place to start is to talk to a financial advisor who can help you understand which types of investments make sense for your goals. Once you are clear on that, you can create a mix of different asset classes, such as stocks, bonds, mutual funds, tax-advantaged retirement accounts, real estate, and even cash if it fits your strategy. When you thoughtfully combine such assets with others, the overall risk is spread, and your potential to earn improves. 

Final thoughts on managing portfolio risk

Knowing how to calculate portfolio risk and managing it effectively are two essential tasks for all investors. You need to understand the risks you are taking and make choices that keep those risks under control. This can be done by considering your financial goals, time horizon, and comfort level, and then shaping your portfolio to fit your needs and risk appetite.

You will not get everything perfect on day one, and you do not need to. With a bit of time, regular rebalancing, and reviewing your strategy every now and then, you can smooth out a lot of bumps. And for anything that feels too complex or overwhelming, you always have the option to bring in a professional. Tools like our financial advisor directory can help you find a financial advisor near you. 

Frequently Asked Questions (FAQs) about management and measurement of portfolio risk and return

1. What are the metrics used for measuring risk?

There are many ways to measure investment risk. Some of the commonly used metrics include the Sharpe ratio, alpha, beta, the M2 measure, the Treynor measure, Jensen’s alpha, and Value at Risk (VaR). Some of these are quite simple to understand, while others can get a bit technical. Speaking to a financial advisor can help you understand these better.

2. Why do you need to measure risk?

Because if you do not measure it, you can’t manage it. When you understand how much risk you are taking, you are better equipped to align your investments with your long-term goals. 

3. How often is rebalancing suggested for portfolio and risk management?

Rebalancing periodically, such as once a year, may be enough to stay on track. However, certain situations may call for extra attention, such as significant market volatility, major changes in your income, or life milestones like retirement.

4. How do you manage risk?

Diversification, aligning your investments with your goals, staying informed, and knowing what each asset brings to the table can help with portfolio and risk management. And of course, working with a financial advisor can also be beneficial.