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When it comes to investments, whether it is a stock, bond, or any other security, there is some degree of risk. Every investment portfolio has its own degree of risk, and this is known as portfolio risk exposure.
The higher the risk amount, the greater the potential losses that could be sustained by an investor. However, the higher the at-risk amount, the greater the potential returns that could be earned as well.
What is Portfolio Risk Exposure
Every investment portfolio consists of different asset classes such as stocks, bonds, mutual funds, real estate, and other investments.
The overall risk of the portfolio is measured by how much money can be lost if the investments within it decline in value. The portfolio risk calculation measures volatility over a while, usually one year. However, it can be determined over shorter or longer periods as well.
The risk calculation takes into account not only the performance of the investments in the portfolio but also how they interact with one another. It measures overall risk by looking at how likely it is that the portfolio will be unable to meet its expected goals.
Different Types of Portfolio Risks
When calculating the portfolio risks, there are several types of risk to take into account – these include
- Market Risk
The biggest risk of all is the market risk – this is the risk that the value of the investments in a portfolio will decline due to economic or political factors.
There are mainly three types of market risk
- Interest Rate Risks: This is the risk that interest rates will go up or down, causing the value of bonds to change.
- Equity Risk: This is the risk associated with investing in stocks. When stock prices decline, a portfolio’s value can be affected.
- Currency Risk: This is the risk of a currency losing its value due to exchange rate fluctuations.
- Liquidity Risks
Investments such as mutual funds and stocks are easy to buy and sell, but other types of investments such as real estate may not be so easy to liquidate. So if any portfolio contains illiquid investments, there is a liquidity risk that needs to be taken into account.
- Credit Risk
This is the risk of an investment not performing as expected due to default or insolvency of the issuer. This type of risk is usually associated with fixed-income investments such as bonds and other debt instruments.
- Inflation Risk
This is the risk that inflation will outpace an investment’s performance, resulting in a loss of purchasing power for investors who own the investments.
However, this risk can be mitigated with investments that offer inflation protection such as Treasury Inflation-Protected Securities (TIPS) or precious metals such as gold.
How to Reduce Portfolio Risks
The best way to reduce portfolio risks is to diversify the investments within it as much as possible. This means investing in a variety of asset classes and ensuring that no single investment makes up too large a portion of the portfolio’s holdings.
Another way to reduce risks is to buy low-risk investments, such as government bonds or certificates of deposit (CDs). These investments are generally considered to be low-risk, but they may also offer a lower return than riskier investments.
Finally, investors should also consider investing in index funds or other passive investment strategies as these can help to reduce the overall risk of the portfolio while providing decent returns.
By diversifying, monitoring the markets closely, and understanding the different types of risk, investors can reduce their portfolio risks and achieve their financial goals.
In conclusion, portfolio risk is an important measure of the overall risk of a portfolio and its ability to meet its goals. By understanding the different types of risk, diversifying investments, and monitoring the markets, investors can reduce their portfolio risks and achieve their financial objectives.
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