Each investment carries a risk of loss. The higher the potential returns, the higher the risk. If you hold a portfolio with many investments, each of those investments carries its own risk. All of the investment risks combined result in an overall risk you have exposed your portfolio to. You must monitor your portfolio risk to make sure you have a variety of investments whose high and low risks offset each other.
Diversify to Minimize Your Risk
You can take a chance on some high-flying investments if you balance your portfolio with some slow-but-steady investments. You should rate each investment on a risk scale that you devise, or use the risk ratings of analysts. The mix of safety and risk is up to you, based on your tolerance for risk. If you want to preserve capital, you should weigh your portfolio toward the safer end of the spectrum. If you desire to grow your portfolio quickly, you will want to select more high-risk investments. No portfolio, no matter what your goal, should hold only one class of investments. Diversify among several types of risk so that you can keep your cash working for you no matter what happens.
Know Your Average Return
One stock may provide a 10-percent return, while a bond may pay you 7 percent. Perhaps a real estate investment trust pays you a whopping 20 percent. Whatever you hold, you must average your returns together to determine your portfolio return. Add up the full value of your portfolio, and then determine the amount you made on it last year. Divide the amount you made by the value and multiply by 100. This figure is your average return. Compare that to the returns of the stock markets, bond markets, real estate markets, and any other investment market you participate in. These markets publish their returns annually. If you are beating the market, you know you are taking some risks that have paid off -- but this trend may not continue. If you are under-performing the market, you know you have chosen safer investments that have less potential for growth than the general market.
In addition to the risks you face in the marketplace, you must consider factors outside of the markets. These include war, political unrest, natural disasters, economic decline, and weather -- which especially affects many commodities. Though you have no control over systemic risk, if you stay aware of trends and news, you'll be better prepared to anticipate ways your portfolio may be affected by some events. For example, if an oil-producing country experiences turmoil that could lead to war, oil prices could soar. This is good news if you invest in oil, but if you hold stock in a car company that produces gas guzzlers, you may reasonably be concerned that the company’s sales could be hurt by high gas prices.
The Kelly Criterion
A scientist named James Kelly who worked at Bell Labs came up with a formula for determining portfolio risk. The complete Kelly Formula involves much math, but it boils down to this: the better your information, the lower your risk. If signs convince you that a particular investment is ripe for a rise, you can actually make above-average returns with lower risk. This depends on the quality of your information and the astuteness of your analysis. For example, if you become convinced that the real estate market has bottomed out, you would consider your investment in real estate much less risky than those who do not see what you see in the real estate market. They would rate the risk much higher than you would. Evaluate your portfolio risk in terms of the quality of your information and analysis.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.