Join our community of smart investors

How to pinpoint risk

A more detailed risk analysis of a recent reader portfolio highlights he is doing a good job versus the FTSE 100 but the likelihood of heavy losses could be reduced with more asset diversification.
August 26, 2016

Many investors take a bottom-up approach - they select holdings based on individual investment cases, rather than looking at the reward-to-risk profile of their portfolio as a whole. One of the main problems in moving towards more holistic strategies, however, is the historic difficulty in quantifying (and therefore managing) risk adequately.

In the past, flawed statistical models have prevailed for reasons of mathematical expediency (see box: Bell tolls for Gaussian assumptions). Therefore, the most sensible way for many people to manage risk has been by mental accounting: they view equity holdings as separate from other assets and sources of income, so are happy to pick stocks on the individual investment cases, as this is 'the risky stuff' anyway.

Mental accounting is perfectly valid, especially if it ensures mistakes aren't costing people their homes or money they depend on to get by, although thinking more scientifically about portfolio construction can help achieve the most efficient trade-off between risk and potential returns. As a caveat, no risk management system can ever be perfect and there is still no substitute for common sense. The first rule of investing should be not to put money on the line if an adverse outcome would prove ruinous.

To continue reading...
REGISTER FOR FREE TODAY
  • Read 3 articles for free each month
  • Educational articles and topical investment guides
  • In-depth podcast episodes by our writers and industry professionals
  • Interactive live webinars on investment themes that matter
Have an account? Sign in