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Best Practices to Evaluate Your Portfolio Risk

Earning profits is only one side of the coin when it comes to being a successful investor.

Proper portfolio construction means taking into account what type of risk you are subjecting your investments to as well. Portfolio risks include market volatility, geopolitical concerns, systemic market risks, foreign currency fluctuations, and more. Without understanding what risk you are taking on when making an investment, you cross the line from investor to gambler.

Check out our Portfolio Management section to learn about more strategies to manage your portfolio.

Getting to Know What Types of Risks You May Encounter

Typical risk analytics are done in the context of an asset’s historical performance to develop a broad base from which data can be accurately taken. While every investor is likely familiar with the standard warning that “past performance is not indicative of future performance,” it’s important to note that historical data sets are used to generate prediction models that are the best estimates of future investment risks.

Risk metrics are not infallible, however, and do come with pitfalls. First, the accuracy of the data that is gathered needs to be easily accessible and plentiful to come up with a model. Time-period bias also plays a role. Analyzing an asset’s risk profile by looking at just the past five years may not be indicative of the asset’s true historical average risk. And. finally, the benchmark portfolio that is being used to compare against can heavily impact the outcome of the risk metrics. For example, a mutual fund that invests in large-cap value stocks shouldn’t use the S&P 500 as a benchmark – it should be compared to a large-cap value stock index instead.

Use the Dividend Screener to find the securities that meet your investment criteria.

Absolute Metrics

Absolute metrics only take into account data from the measured portfolio that is being analyzed. No comparable portfolio or benchmark is used.

Portfolio Standard Deviation

Measuring standard deviation is one of the most often used metrics for analyzing a portfolio’s risk as well as making relatively accurate assumptions about future performance. This calculation takes into account returns over a period of time to determine the range of what average returns should be.

For example, if a portfolio has a standard deviation of 10, then this means that there is a 68% chance that the portfolio’s performance will fall within one standard deviation and a 95% chance it will fall within two standard deviations of norm. Let’s say the expected return of the portfolio is 15% — then there is a 68% probability that the returns will fall within 5% to 25% for the year.


Value-at-risk is more commonly used by financial institutions and measures the number of total risks the company is exposed to and how often those risks will happen. This term is similar to risk-of-loss, which applies more to insurance or legal contracts that specify which party is responsible for bearing the loss or risk. In a portfolio, VAR can be used to determine the maximum possible loss given a set time horizon and a probability figure. For example, if a portfolio has a 10% VAR on $100,000 over 12 months, then it means that there is a 10% probability that the portfolio will lose more than $100,000 in that time frame.

Shortfall Risk

Finally, shortfall risk is where a portfolio doesn’t generate high enough returns to achieve the intended goal. This is common in retirement planning where being too conservative and taking on too few risks actually ends up costing the investor more in the end by generating fewer-than-expected gains.

Relative Metrics

A relative metric is an analytical tool that needs to be compared to another benchmark portfolio or index such as the S&P 500. This allows investors to gauge their portfolio’s performance and get a better idea of how well it did and what changes may need to be made. Investors should note that tracking errors can occur where the benchmark index and the portfolio may begin to diverge over time, making the comparables less useful to investors.

Sharpe Ratio

The Sharpe ratio is one of the best tools investors can use to compare the returns they received within a portfolio compared to the amount of risk they took on. The calculation is relatively straightforward:

Sharpe Ratio = (Rp – Rf) / σp

Rp = The return of the portfolio
Rf = The risk-free rate
σp = Standard deviation of the portfolio

The risk-free rate is subtracted from the portfolio’s returns and then divided by the standard deviation to find a number that can then be compared to a benchmark portfolio. The higher the number, the better the portfolio did compared to the inherent risk in the assets it holds.


Beta is a simple risk metric that most mutual funds and even individual stocks generally have available by way of a screening tool. This risk metric measures how strongly correlated the portfolio or asset is relative to a benchmark index. A beta of 1 means that they are perfectly correlated – for every 2% up or down movement in the benchmark, investors should expect to see that same performance in the asset.

Treynor Ratio

The Treynor ratio is commonly known as the reward-to-volatility ratio and measures returns comparable to undertaken risk in a similar way that the Sharpe ratio does, but takes into account volatility rather than standard deviation.

Be sure to check here to know the implications of portfolio rebalancing.

The Bottom Line

Risk management is something that every investor should become familiar with to maximize their gains and minimize potential losses. Understanding when and where different risk metrics can be used will help investors develop better portfolio construction designs and become more efficient at achieving their intended goals. Knowing how a risk metric is derived, and the downfalls of relying on them solely, will keep investors from making costly mistakes.

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Sep 05, 2019