Portfolio Risk Management | Meaning, Types & Examples - Lesson | Study.com (2024)

Portfolio management reserves are an essential part of managing your portfolio. They are an amount of capital you keep back to hedge risks and ensure that your portfolio is liquid enough to cover any unforeseen losses. Hedging seeks to protect financial assets from the potential for unfavorable price movements by leveraging financial products or market tactics. Investors essentially leverage a trade in one investment to safeguard another.

For example, an investor may have a portfolio worth $100,000 but decide to keep $10,000 in reserve; that way, even if their portfolio drops by over 10%, they can still break even.

Liquidity refers to how quickly a portfolio can be converted into cash without significantly losing value. By maintaining a portfolio management reserve, investors guarantee that they have the liquidity they need in a crisis or when opportunities arise.

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A Portfolio Risk Management Plan (PRMP) is important to any organization's overall strategy. It helps organizations develop and maintain a comprehensive list of risks associated with their portfolios and how they are managed.

Governance risk focuses on government policy, regulatory changes, and legal requirements while ensuring compliance across the enterprise. A risk register is a major component of the PRMP that provides information about identified risks at the portfolio level. Its purpose is to track and monitor identified risks so that necessary adjustments can be made. By implementing a Portfolio Risk Management Plan, organizations can minimize their exposure to strategic risk at the portfolio level both now and in years to come.

Ultimately, portfolio risk management is an essential part of financial planning and should be a regular component of any investor's portfolio strategy. Understanding the risks associated with investments and implementing strategies to reduce them can help investors maximize their returns while minimizing their losses. Understanding investment risks and employing risk-mitigation strategies can assist investors in maximizing profits while minimizing losses.

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When developing an effective portfolio risk management plan, it is critical to understand the many risks to which an investor is exposed. Finding the correct balance of stocks and bonds in the portfolio is a basic example of this.

Renata is researching an investment in a real estate development project that will add a new shopping center in her hometown. She identifies each of the following risks:

  • Credit risk: The construction contractor has several outstanding loans. The contractor used building equipment as collateral, so there is a risk that a lender will seize the equipment if the builder defaults.
  • Market risk: Real estate values have rapidly increased recently. This shows a bubble, so values may drop in the future.
  • Interest-rate risk: Renata finds that interest rates have been stable, but their news reports show the Federal Reserve may raise rates soon.
  • Inflation risk: Inflation has increased in the area, so consumers may have less buying power. This could cause stores to hesitate before renting space in the new retail center.
  • Governance risk: The city government must issue various permits for the project to proceed. Delays or denials result in missing construction deadlines or even cancelling the project.

Investors can develop customized portfolios that fulfill their financial goals while decreasing their total risk exposure. This method includes evaluating the various risks associated with particular asset classes and efficiently allocating them.

Now that Renata has identified the risks, she can evaluate them to see if she wants to include the project in her investment portfolio. Careful market monitoring is also essential in ensuring that these portfolio allocations remain within predetermined risk parameters for effective long-term investment performance.

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Portfolio risk management balances the risks associated with a portfolio's investments. By proactively assessing the market, interest rate, inflation, and credit risk, investors can make more informed decisions when investing their money. Also, portfolio management reserves help provide liquidity in case of unexpected losses or opportunities. Simultaneously, a Portfolio Risk Management Plan ensures a full understanding of the overall strategy and helps address any risks at the portfolio level. There are four types of risks to manage. Portfolio risk management evaluates how likely it is that stocks, bonds, money market funds, and cash will return less than expected. Credit risk refers to the uncertainty of whether a bond issuer can repay their debt. Market risk occurs because of fluctuations in the financial markets.

Interest rate risk is caused by changes in the interest rate, which cause a decrease in the value of investments. For example, the value of a stock might fall when the interest rate increases. Inflation risk entails the erosion of purchasing power, which detrimentally affects investments. This risk is assessed through measures such as price-to-earnings ratios. Maintaining a portfolio management reserve ensures investors that not all of their holdings are locked up in speculative investments. By setting aside a certain percentage, they can ensure the security of their assets while still making shrewd decisions with their money. Investors keep a portion of it on the sidelines to ensure they can adjust their portfolio in case of future risks. Governance risk procedures and protocols focus on regulatory modifications, policy handling, lawful obligations, and political awareness for optimal performance. In order to ensure success, any risk associated with investments must be carefully measured against the chance that it will become an issue. Portfolio risk management evaluates how likely it is that stocks, bonds, money market funds, and cash will return less than expected.

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Video Transcript

Portfolio Risk Management

Megan is a senior investment analyst who oversees several agency portfolios. She spends most of her day administering the portfolios, transferring funds, rebalancing investments, and communicating with clients. Her specialty is high-risk investments. She is an expert in portfolio risk management.

Portfolio risk management is the collection and analysis of risks across individual portfolio investments, such as stocks, bonds, money market funds, and cash. Risk is the probability that actual investment returns are less than those that are projected. Of course, Megan's goal is to get the highest return on an investment possible. She must be ahead of every other investor when it comes to predicting risk. She needs to make investments that meet her company's strategic goals and objectives and don't waiver from the client's business values. If an investor wants to invest in only environment-friendly ventures, Megan must support it. But she needs to balance these goals and objectives against portfolio risks. Portfolio risks include market risk, interest-rate risk, inflation risk, and credit risk:

  • Market risk is the probability that the value of an investment follows the rise and fall of the stock market. For example, if the stock market is declining, Megan needs to shift her investments to bonds in order to counteract this decline.
  • Interest-rate risk is the risk that the value of an investment will fall as the interest rates rise. For example, if Megan purchases bonds, there is a chance that their worth will decrease with increasing interest rates.
  • Inflation risk is the chance that the value of an investment declines because of the interest rate. For example, if Megan invests in X stock and its growth does not keep up with the rate of inflation, she'd be losing money.
  • Credit risk focuses on whether a bond issuer can repay a bond debt once it matures. For example, if Megan invests in junk bonds, she is taking a chance on higher payoffs with higher risk.

To manage the unpredictability of these risks, Megan keeps portfolio management reserves available. Portfolio management reserves are shares of the portfolio reserved as protection and used to maximize investment returns and ensure that there is enough liquidity available when portfolios need to be restructured. Liquidity is important because it is the ability of an asset to be bought and sold quickly, without affecting the worth of the asset. It is a function of stability. Enough liquidity means that Megan has the ability to quickly rebalance portfolios when the risks get too high.

Portfolio Risk Management Plan

Megan always has a portfolio risk management plan. Her portfolio management reserves sit at 20%. This means that part of each portfolio is reserved so the value of the risk doesn't outweigh the estimated value of the portfolio. Each individual investment then becomes a part of a risk register, a risk management plan that focuses on each investment's potential impact on a portfolio. The most important piece of the risk register is developing a list of potential portfolio risks that include market risks, interest-rate risks, inflation risks, and credit risks. This register also includes:

  • The likelihood that a risk will become a problem
  • The consequence if the risk occurs
  • Risk rank among other risks
  • Risk triggers that would create the need for a rebalancing
  • A prevention plan to avoid risk
  • An investment contingency plan.

When Megan sees an opportunity to capitalize on risk, she can leverage her organizational assets to quickly do so. Her governance risk guidelines, processes, and procedures focus on regulatory changes, policy management, legal requirements, and political awareness. These guidelines are broad-based environmental changes that affect how she mixes investments for her clients' portfolios. She balances long- and short-term risks, keeps her investments flexible when the political environment is unstable, monitors legal changes, and reads policy briefs on thorny initiatives.

Lesson Summary

Portfolio risk management is used to oversee the risks associated with investment portfolios. These portfolio risks include market, interest-rate, inflation, and credit risks. They are summarized in a risk register and balanced with governance risk guidelines and portfolio management reserves. It's important the portfolio has enough liquidity so that it can be rebalanced when risks are too high.

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Portfolio Risk Management | Meaning, Types & Examples - Lesson | Study.com (2024)


What are the 4 different types of portfolio management strategies? ›

The four distinct types of portfolio management are active, passive, discretionary and non-discretionary management.

What is portfolio management and example? ›

Portfolio management is the art of investing in a collection of assets, such as stocks, bonds, or other securities, to diversify risk and achieve greater returns. Investors usually seek a return by diversifying these securities in a way that considers their risk appetite and financial objectives.

What is portfolio risk with an example? ›

Portfolio risk is a term used to describe the potential loss of value or decline in the performance of an investment portfolio due to various factors, including market volatility, credit defaults, interest rate changes, and currency fluctuations.

What are the four steps in managing portfolio risk? ›

There are four key steps to the portfolio risk management process. 1) Identify portfolio risks 2) Analyze portfolio risks 3)Develop portfolio risk responses 4) Monitor and control portfolio risks — portfolio risks and mitigation plans should be tracked at Portfolio Governance Team meetings.

What are the 4 Ps of portfolio management? ›

These are People, Philosophy, Process, and Performance. When evaluating a wealth manager, these are the key areas to think about. The 4P's can be dissected further, but for the purpose of this introduction, we'll focus on these high-level categories.

What are the 5 techniques for portfolio management? ›

Portfolio management: Five investment tips for better return on your money
  • 1) Set Clear Financial Goals. ...
  • 2) Budget & Prioritise Essential Expenses. ...
  • 3) Look At What You Automated. ...
  • 4) Plan For Major Expenses. ...
  • 5) Get Professional Advice.
Apr 13, 2023

What are the 5 phases of portfolio management? ›

Steps of Portfolio Management
  • Step 1: Identifying the objective. An investor needs to identify the objective. ...
  • Step 2: Estimating capital markets. ...
  • Step 3: Asset Allocation. ...
  • Step 4: Formulation of a Portfolio Strategy. ...
  • Step 5: Implementing portfolio. ...
  • Step 6: Evaluating portfolio.
Oct 12, 2023

What is portfolio manager in simple words? ›

What Is a Portfolio Manager? Portfolio managers are investment decision-makers. They devise and implement investment strategies and processes to meet client goals and constraints, construct and manage portfolios, make decisions on what and when to buy and sell investments.

What is the difference between risk management and portfolio management? ›

Portfolio management is highly multidimensional and data-dependent, it is forced to be at least partly parametric. Risk management is low-dimensional and uses much less data, it relies on non-parametric methods.

How to calculate portfolio risk? ›

To calculate the risk in the portfolio, you can use the formula: σ P = w A 2 ⋅ σ A 2 + w B 2 ⋅ σ B 2 + 2 ⋅ w A ⋅ w B ⋅ σ A ⋅ σ B ⋅ ρ A B where: - stands for the portfolio risk, - and are the weights of investment in asset A and asset B, - and are the standard deviations of returns of asset A and asset B respectively, - ...

What makes a portfolio high-risk? ›

A high-risk investment is one for which there is either a large percentage chance of loss of capital or under-performance—or a relatively high chance of a devastating loss.

How to identify portfolio risks? ›

Common measures of risk include standard deviation, beta, tracking error, and drawdowns. Standard risk management strategies include diversification, hedging, and asset allocation as well as using a risk budget and establishing target sell prices.

What are the 4 C's of risk management? ›

Start by practicing good risk management, building on the old adage of four Cs: compassion, communication, competence and charting.

How to create a risk portfolio? ›

  1. 1 Identify portfolio risks. The first step is to identify the possible risks that could affect your portfolio as a whole, as well as the individual projects within it. ...
  2. 2 Analyze portfolio risks. ...
  3. 3 Plan portfolio risk responses. ...
  4. 4 Monitor and review portfolio risks. ...
  5. 5 Here's what else to consider.
Aug 23, 2023

What are the types of strategic portfolio management? ›

The two main types of portfolio management are active and passive investing. Active investing involves frequent trading to take advantage of market trends or opportunities for profit, while passive investing relies on buying and holding assets for an extended period.

What are the strategies of portfolio management? ›

Strategic Portfolio Management Use Cases
  • Real-time visibility into capital budgets and investments. ...
  • Build capital plans that maximize ROI. ...
  • Optimize the capital portfolio. ...
  • Revisit strategic direction. ...
  • Reallocate funding. ...
  • Reprioritize investments. ...
  • Realign teams and work. ...
  • Review performance.

What are the 5 types of portfolio? ›

Types of Portfolios
  • Aggressive Portfolio: An aggressive portfolio aims to maximise returns while taking a relatively high degree of risk. ...
  • Conservative Portfolio: This portfolio is designed for low-risk tolerance investors, such as those with short-term goals. ...
  • Income Portfolio: ...
  • Speculative Portfolio: ...
  • Hybrid Portfolio:


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