The goal of a portfolio is to generate positive returns and conserve capital. However, there are always competing forces at play. Trying to achieve high returns comes with the caveat that you must take on higher risk. Some investors aren’t willing to do that. So investor risk profiles come into play.
Even for investors who are fine with lower returns for lower risk, their portfolios still contain risk. Understanding risk factors when planning a portfolio can help investors to manage those risks better. Let’s go through some portfolio risk factors investors should consider.
Understanding what's going on in the larger economy and globally is a great place to assess potential risk consistently. A macro view can drive where money may be invested. A macro view can also help manage risk as well.
Some macro considerations are the business cycle, political environment, and overall consumer sentiment. For example, is the cycle expanding, peaking, or contracting? Are politicians trying to apply a lot of regulations to businesses or raise corporate taxes? Do consumers feel confident in the near term future?
Those are just a few examples, but there are many questions to ask at a macro level to help with risk management. Keeping tabs on the news and doing deep dives into areas that can impact your investments will also help.
Sector performance analyzes certain industry sectors and how they may perform under different macro conditions. Knowing which sectors your investments fall into will narrow down the sectors that you need to follow.
Sectors are also impacted by seasonality. For example, some hospitality companies flourish during warmer months while underperforming during cooler months. Additionally, fuel cost can affect travel, which may negatively affect hospitality.
In 2022, autos were impacted by chip shortages. This is not a demand issue but rather one of supply. Consumers still want to buy new cars, but the supply isn't there. This shortage of new vehicles has driven consumers to purchase used cars at high prices.
Knowing that the auto industry may be experiencing a pullback due to supply rather than demand issues can inform investment decisions in this sector.
Credit risk is an analysis of a company's financial solvency. In other words, will the company continue paying its bills and not go bankrupt? For investors, the risk is that they can lose any capital invested in a company due to bankruptcy.
To help analyze credit risk, rating agencies issue ratings for public companies' debt (i.e., bonds). That only helps if you are dealing with a public company.
For private companies, more work and access is required. Unless you have access to a company's financial statements, you can’t really determine its credit risk. Some private companies will publish limited financial information. While some financial information is better than none, it still doesn’t allow investors to make an informed decision.
Liquidity risk is an inability to convert an asset to cash quickly. Often, if an investor wants to convert an illiquid asset to cash promptly, he'll have to sell it below the market value.
For long-term investors who are well-capitalized, they have the luxury of holding illiquid assets. Investors who might need to raise cash because of an emergency may find they'll have to take a significant loss on an illiquid investment. This loss is due to the illiquid nature of the asset and, in some cases, penalties for selling before the asset matures.
Lack of Diversification
Diversification can help spread risk across different asset classes. A portfolio that is invested in only one asset class concentrates its exposure. If that one asset class experiences a significant decline in value, so will the investor’s portfolio.
Different asset classes with different correlations provide portfolio diversification. Different positive correlations mean that some assets will drop in value less than others. While negative correlations mean that as some assets are dropping in value, others are increasing.
There are many risk factors to consider when planning a portfolio. Some risks will be specific to certain assets, while other risks will be specific to asset classes, sectors, and even countries. Working with a financial advisor can help in managing risk and creating a well-diversified portfolio.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.