Types of Investment Risk and Rate of Return in Portfolio Management

Investment Risk

Portfolio management requires understanding the types of investment risk and rate of return in today’s environment. It is a given that an investor must take risk in order to achieve rates of return above a risk-free rate of return. Because the risk-free rate of return (i.e. Treasury Bills rates) is near zero; most investors are being forced to accept additional risk to achieve investment returns that will meet their long term goals.

What is Investment Risk?

Most of us think of risk as negative. I’m going to try and get you to think a little differently about it. Risk is a deviation of an expected outcome. In investing, we can look at risk as a deviation of expected investment return. The deviation can be either positive or negative. The probability and magnitude of the deviation is what an investor is concerned about. There are many factors that can affect risk and there are portfolio management tools to measure and mitigate the factors.

Understanding risk and return allows a portfolio manager to manage risk and optimize returns. Before we examine how to analyze risk we need to look at some different types of risk and how a portfolio manager can use the tools available to improve their probability of higher returns.

Types of Investment Risk

Two Most Important Risks:

Specific Risk – The individual asset such as a company can have problems that are specific to that asset. Maybe a catastrophe (i.e. BP oil spill), bad management, a large product failure, etc. causes the individual assets price to fall. Specific risk can be mitigated with diversification.

Market Risk – In the short term stock market prices cannot be predicted. But long term returns can be predicted with some accuracy. In other words, the variation of returns (risk) is less over long periods of time than short periods of time. The stock market has fallen 30 -50% many times in short periods of time, but it has never fallen even 15% over a 10 year period. Market risk can be mitigated by long term investing, using a tactical asset allocation strategy, and hedging.

Other Risks to Consider:

Interest Rate Risk – When interest rates increase the price of bonds decline.

Default Risk – Sometimes a company is unable to pay back debts or bills.

Longevity Risk – Living longer than your money.

Inflation Risk – Higher prices lower the purchasing power of your investments. If your investment returns don’t exceed inflation you are losing purchasing power.

Economic Risk – Economic recession and depression can increase the risk of an investment.

Political Risk – Because the government is involved in a large percentage of our lives; changes in policies can have profound effects on entire industries or even the whole economy.

Self-directed Portfolio Management

I believe there are advantages to self-directed portfolio management. The person who has everything at stake can make the best decisions. I hope the importance of investment risk and rate of return in portfolio management is evident. It’s everything; and therefore critical for a portfolio manager to understand.

In the following posts, we will look at standard deviation, alpha and beta, and Modern Portfolio Theory. Before your eyes glaze over with boredom I promise to show you how these concepts are helpful without getting too technical.

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