Portfolio risk is the combined risk of each individual holding within a portfolio. This level of risk is affected by each holding itself, its interaction with other holdings and their weightings. Understanding and quantifying risk is key to portfolio management and optimising potential returns. It will allow you to make informed decisions on what you invest in, and how, allowing you to chase higher returns in a more comfortable manner.

Some of the types of risk you should consider when choosing funds or shares are liquidity – how easy it is to sell; default – the likelihood of the institution failing; regulatory/political – changes to regulatory rules or political practices that could impact performance; duration – effect of interest rate changes; and style – how the investment manager picks his holdings.

Generally, the above risk types can be easily mitigated by proper diversification, but overall portfolio risk is a little harder to manage.

The most potentially damaging type of risk in a portfolio is market/systematic risk. As most asset types correlate in some way, a down-turn in the stock market will result in most holdings following suit. The best way to mitigate this is to choose a diverse range of asset classes with as little correlation to each other as possible. Simply put, this means buying umbrellas and sun cream; when one is in demand the other is not, and vice versa. This should reduce fluctuations in volatility.

Concentration risk is having too much exposure to one sector, region or asset type. This makes your portfolio susceptible to regulatory or systematic risk. This can even happen if you have dutifully selected non-correlated assets e.g. Chinese equities, commodities and emerging market currencies would all be affected by a fall in the Chinese economy, but on the surface, these would all appear to be well-diversified.

Inflation risk is a real threat (especially today). This means the portfolio’s purchasing power keeping pace with inflation over time. Holding ‘risky’ assets such as equities is a common long-term tactic to try and outperform inflation.

Similarly, interest rate and currency risk should also be considered.

There are several ways to measure risk, and these are usually combined, as no one way can capture all the aspects.

Volatility is the most common indicator of risk and is measured by the ‘standard deviation’ from the average price. This is a complex calculation, but a high deviation means an investment is riskier as the price moves away from the average more wildly than one with a low deviation which indicates prices are calm and therefore less risky.

Lastly, determining your tolerance, appetite for risk and capacity for loss is particularly important when constructing or managing your portfolio. This is where how much you can ‘afford’ to lose is tempered with how much you are ‘willing’ to lose/gain and considers things like your investment time horizon, other sources of income or reliability on investment income.

Always remember that past performance is not a reliable indicator of future returns and the key to long-term success is to not only measure overall risk, but also risk in relation to returns. If you would like to discuss your existing investment portfolio or advice on creating the right one for you, we would be happy to assist.

For further information please visit www.spectrum-ifa.com. Mark Quinn is a Chartered Financial Planner with the Chartered Insurance Institute and Tax Adviser, qualifying with the Association of Tax Technicians. Contact Mark, at: mark.quinn@spectrum-ifa.com