Risk and Portfolio Context - Essay Example

?Running Head: Risk and Portfolio Context Risk and Portfolio Context [Institute’s Risk and Portfolio Context Introduction Finance is all about allocation of an individual’s assets in such a way that these assets generate return over them so that their value increases with time and inflation, and provides financial benefit to the investor. Investment, though necessary for a secure future, is a very risky business. It has the ability to help the investor in building a secure future if done with proper care and at the same time have the ability to ruin the investor present by failing. This unpredictable nature of investment makes it very necessary that investment decisions are taken with proper care so that fruitful results are achieved. Risk in Investment Risk is a core element of investment and is inseparable from investment function. According to investment theories and actual practices, it is evident that there is no possibility of return over the investment without the assumption of risk in that investment by the investor. A conscious and willing assumption of risk by a knowing investor, expecting to earn a measure of return, lies at the heart of investment process (Sedleck, 2008, pp.1). Webster defines risk as “the possibility of loss or injury” (Sedleck, 2008, pp.3), in investment risk is the possibility of monetary loss through the loss in value of the investment instrument. Risk is a subjective measure with many possible definitions. This is because different investors adopt different investment strategies to attain their investment objective. Therefore, the subjectivity of the risk is its only main characteristic. It is an unavoidable function of investment, intelligent investment strategies can help to reduce it but nothing can help to ignore, negate or make risk zero (Sedleck, 2008, pp.3). Types of Investment Risk Investment risks are of two types systematic and unsystematic, however, they hole various other kind of risk in these two head branches of risk. The risks associated with investments are as follows: Systematic Risk It is the market risk, related to the factors the complete market economy or securities market. This kind of risk is beyond the control of the investor. As it is a market risk, it affects all the companies in the market irrespective of the company financial position, capital structure and management position. It involves domestic and international factors, depending upon the kind of investment (FINRA, 2013). Types of Systematic Risks Interest rate risk is the risk that due to change in interest rate over time will result in value of security going down (FINRA, 2013). Inflation Risk is the risk of decrease in purchasing power due to increase in prices of goods and services and cost of living (FINRA, 2013). Currency Risk arises due to world currency floating against each other. The reason for this risk is the change in exchange rate. Change in exchange rate can affect the return on a foreign currency investment in positive as well as negative way. This risk occurs only in circumstances of investment in international securities and funds (FINRA, 2013). Liquidity Risk is the risk that an investor might not be able to purchase and sale investments quickly at the price that is close to the actual underlying value of that investment. It is higher in over the counter markets and small-capitalization stock (FINRA, 2013). In case of foreign investment the timing of dealings, market size and number of listed companies can affect an investor’s ability to buy or sell foreign investment (FINRA, 2013). Socio-political Risk is the risk of adverse effect of instability and unrest in one or more region of the world on the investment market (FINRA, 2013). Defence against Systematic Risks An investor’s defence against systematic risk is the strategy of asset allocation. This strategy dictates that the investor should build an investment portfolio with such investments that react differently to same economic factors. It involves investing in bonds as well as stocks because historical pattern indicates that when bonds are providing a good return, stocks tend to provide a poor return and vice versa (FINRA, 2013). Non-Systematic Risk Non-systematic risk is associated with investment in any particular product or industry sector. The reduction of this risk is possible by the investor because it affect a small number of companies or investment, contrary to the systematic risk (FINRA, 2013). Types of Non-systematic risks Management risk is a risk majorly related to the internal factors of the company and that is why is also known as company risk. “It refers to the impact of bad management decision, internal missteps, or even external situations can have on a company performance and as a consequence on the value of investment of that company” (FINRA, 2013). It is difficult to anticipate management risk of a sound company for future. Credit risk is the risk of default. It is the risk that bond issuer will not be able to pay interest as scheduled on principal on maturity (FINRA, 2013). Defence against Non-systematic Risks The major defence for an investor’s investment from non-systematic risk is diversification of portfolio. If a portfolio holds investment from each major asset class, the negative impact of a particular asset will be less traumatic because of it being one of the many investments made instead of being an only investment (FINRA, 2013). Investment Portfolio Investment portfolio is a collection of different investment assets held simultaneously by the investor to help achieve his goal of investment. For portfolio formation, it is a generally accepted principal that the portfolio design is according to investor’s investment goals, risk tolerance and timeframe (Kevin, 2013). An investment portfolio can comprise of different combinations of assets ranging from stocks, options, bonds, bank account, certificates etc. Thus, a portfolio can include any item that is likely to retain its value over time and produce a return. An investment portfolio within itself can contain sub-portfolio and asset bundle of different assets, depending upon the investor’s approach towards investment (Kevin, 2013). Types of Portfolio There are different types of basic portfolio developed as per the needs of the investor. The types of portfolio are: Aggressive Portfolios are the portfolios for investors that have high-risk tolerance, longer time horizon and aims for highest possible return over their investment. These portfolios will consist of majorly equities and bonds and have a smaller section of cash and cash equivalents (Investopedia, 2013). Conservative Portfolios are the portfolios for investors who value their investment safety at a high priority, so are risks averse, and have shorter time horizon. These portfolios consist of cash and cash equivalents and fixed return instruments (Investopedia, 2013). Risk Assessment in Portfolio An investment risk can be judged in terms of every single asset or in terms of investment portfolio context. Modern Portfolio Theory is the theory, which guides the investor on how to build his portfolio and how to manage its risk. This theory was the first bases of stating that investment risk is best judged in portfolio context. The theory explained the concept of portfolio, its need and the reason for considering risk assessment in portfolio context as the best measure of risk assessment. Risk is best judged in portfolio context because investor’s prudence towards diversifying his investments to earn better return. As most investors diversify their investment and avoid putting all of their eggs in one basket this makes it impossible to judge the effective risk of any security by the examination of that security alone. It is so because in a portfolio, a part of uncertainty associated with any security is diversified by grouping that security with other securities in the portfolio. This is why risk assessment of any asset/security, which is a part of investment portfolio, is not done on standalone bases of that security because it fails to give the accurate risk assessment result (Brealey and Meyers, 2003, pp.182). Any prudent investor does not invest all his investment in a single security because of the risk associated with investment, instead a prudent investor build an investment portfolio so that he can divert systematic and non-systematic risks faced by his investment in such a way that these risk result in minimum possible harm to his investment. As risk avoidance is not possible but only its diversification to a certain extent is possible, diversification of investment is important so that the whole investment does not lose their value and investor is able to enjoy a return over them. In this scenario, assessing risk to investment on the bases of each asset individually, do not provide a correct picture of the risk effect or the possible risk that would affect the complete investment. Because an investment portfolio not only possess the characteristic or risk and return of a single stock but also contain the irregularity of risk and return of the relationship between the securities held in the portfolio. This is because of establishing a diversified portfolio where selection of every security for the portfolio is in such a way that it helps to reduce the risk probable to the investment due to the other securities in the portfolio. Due to this investment risk for a portfolio of investment is done in the context of portfolio and not individually, so that the investor can get a complete and true picture of his investment. Value at risk (VAR) is the method usually used to assess the risk to the portfolio on a whole. This method helps to assess the largest possible loss that can be suffered by the portfolio through all truly exception periods. It also helps to assess the potential loss on the portfolio (Hopper, 1996). Conclusion The above discussion concludes that due to the investment prudence and goal of the investor to reduce the different type of investment risk to his investment, the investor builds a diversified portfolio. Due to this diversified portfolio and the reason above stated, the statement that risk is best judged in a portfolio context stands true. This diversification of portfolio makes the best assessment of investment risk in portfolio context rather than of individual asset bases. References Brealey, R. and Myers, S., 2003. Principles of Corporate Finance. The McGraw-Hill Company. Finance Industry Regulatory Authority (FINRA). 2013. Smart Investing. Finance Industry Regulatory Authority, [online] Available at: Hopper, G., 1996. Value at Risk: A New Methodology for Measuring Portfolio Risk. Business Review, [online] Available at: http://www.philadelphiafed.org/research-and-data/publications/business-review/1996/july-august/value-at-risk.cfm [Accessed on April 04, 2013]. Investopedia, 2013. Investing 101: Portfolio and Diversification. Investopedia, [online] Available at: http://www.investopedia.com/university/beginner/beginner6.asp [Accessed on April 04, 2013]. Kevin, 2013. What is an Investment Portfolio? Your Guide to Investing, [online] Available at: Read More