What is Investment Risk?

Investment risk definition:

Investment risk is the possibility that a chosen investment will not provide the expected return. Due to market fluctuations, your investment may have a lower than expected return, or you may lose all or part of the initial investment.

In general, the investments with more expected return have more associated risk. But you can also have portfolios with high risk and low return, or moderate returns and quite low risk. 

Just as Warren Buffet (one of the most successful investors in the world) says, "Risk comes from not knowing what you are doing."  You really need to know what you are doing. First, you need to know your goals and then you need to craft a portfolio that aligns with those goals. Last but not least, you need to periodically check whether your portfolio is on track and aligned with those goals.

Every investment product has its own risk and return profile. Something important to consider in your journey is:

  • How fast your money will grow.
  • How safe your money will be.
  • How easy you can get the money out when you need them.

Untitled design-Jun-08-2022-04-47-33-34-AM

Investment Risk Types:

There are several types of risk, and the list below is not by any means exhaustive. Here we touch on some of the most often met types of investment risk:

1. Inflation Risk

Inflation is a general upward movement in the prices of goods and services. Inflation reduces purchasing power, which is a risk for investors who receive a fixed interest rate; it also affects savings and the potential return on your investment in general due to less money being allocated to investments. 

2. Political Risk 

Political conflicts or tensions may affect investment returns. This type of confrontation increases nervousness among investors, especially when those conflicts determine increase in demand for assets such as commodities or raw materials. For example, if the price of a rare metal rises, the company's shares that trade in that material will likely also increase.

3. Liquidity Risk

The more difficult it is for an investor to convert the asset he owns into money, the higher is the return that the asset requires. It is because the investor is sacrificing his purchasing power. By not being able to access the your money invested at the time you want, it would be understood as a payment for the sacrifice of purchasing power made.

4. Concentration risk

This is a risk derived from the lack of diversification in investments, and it is what is commonly known as "having all your eggs in one basket". The lack of diversification means that you do not reduce the risk of your investments as a whole. If all (or many of) your investments are focused in a certain industry, you may benefit from excellent returns when that industry does well and at the same time you are exposed to a very high risk of loss when that industry goes down.

 

How to calculate your portfolio risk?

The risk of a portfolio is measured using the standard deviation of the portfolio. However, the standard deviation of the portfolio will not simply be the weighted average of the standard deviation of the assets within the portfolio. It is much complex than that and it is also essential to consider the covariance/correlation between the assets.

The formula to calculate the portfolio risk for a portfolio with 2 (two) investments is as follows:

Untitled design-Jun-08-2022-01-07-09-32-AM
where:
σP = portfolio risk
σ1, σ= risk of investment 1, and risk of investment 2 respectively 
w1, w2= weight (percentage) of investment 1, and weight of investment 2 respectively, in the portfolio 
ρ1,2 = the correlation between investment 1 and investment 2
 
As you can see, the formula is quite complex but relatively easy to calculate for 2 investments if you have all required information (individual investment risks, individual investment weight, granular correlations between pairs of investments). However, as you increase the size of the portfolio (3, 4, ..10 or even up to tens of investments) the formula becomes more and more complex and almost impossible to calculate even in Excel. 
 
 
Why would you spend time to calculate it, when you can use tools to make your life easier?
  

Software to calculate investment risk:

 

Diversiview is a portfolio analysis and optimisation application. Among others, Diversiview helps you measure the risk associated with individual investments and for the portfolio overall. 

Check out how to do that step by step:

Other things you can do in Diversiview include:

- calculate other important portfolio indicators (expected portfolio return, portfolio Alpha, portfolio Beta, Sharpe ratio)

- visualise the real diversification of your portfolio, at security level & see where you may benefit from further diversification

- use powerful tools (unique on the market) that help you optimise your portfolio and calculate those asset allocation that give you the risk-return position you want.

 

Try Diversiview for Free

Diversiview-Jun-08-2022-04-34-19-60-AM

Sign up for our newsletter! 

Laura Rusu

Disclaimer: LENSELLDiversiview® is a trademark of LENSELL GROUP PTY LTD. LENSELL accepts no responsibility for any claim, loss or damage as a result of using the information on this website. The website content is provided "as is" for information purposes only, it should not be considered financial advice nor solely relied upon for making any trading decisions. Please consult a finance professional before buying or selling any securities or before making any other changes to your portfolio.