In the era before modern portfolio theory, the “reasonable man” standard of investment decision making ruled the investing world. Under this theory, an investment manager’s duty was to invest in only those stocks that had high returns and low prices. Any stock that fell in price was viewed as an example of imprudence. In today’s market, portfolio risk is calculated as the beta of all the stocks in a portfolio. This means that if a portfolio is underperforming, then its risk level is high.
The process of portfolio management risk begins by identifying the portfolio-level risks and then evaluating and mitigating them. This process is typically overseen by the project team. During this stage of the process, portfolio risk management involves analysis of the risk and minimizes threats while capitalizing on opportunities. The importance of portfolio risk management cannot be overstated because component failures of a portfolio can have devastating effects on other components. However, a successful portfolio risk management strategy must be flexible enough to respond to such changes.
The risks that a portfolio may face vary, from conventional to complex. The risk model that managers use should take into account both rare and common events. This is because the manager should carefully consider the risk associated with each component of a portfolio. Using a portfolio approach will help them navigate the complexities of the risk landscape, while aligning them with the broader business objectives. A proper risk model will include the likelihood of each risk and the corresponding volatility over time.
While portfolio management is a very complex process, the rewards are well worth it. It can help protect the investment and risk of an organization’s portfolio and reduce its overall risk. After work intake and prioritization processes have been established, an organization can begin portfolio risk management. In recent years, the COVID-19 crisis has exposed the vulnerability of portfolios, especially projects that aren’t managed well. Hence, it is vital to properly manage portfolio risk to ensure success.
The first phase of a portfolio’s life cycle involves selecting and evaluating projects. This phase of portfolio management is critical, and many Portfolio Governance Teams fail to account for risk. Many portfolio management teams take on too many high-risk projects and wonder why their success rate is so low. Smart portfolio management teams take the risk of individual projects and the company’s risk tolerance into account. They also consider the maturity level of the project. For instance, a young professional might have more money to invest in higher-risk projects.
Another key element of risk in portfolio management is the use of leverage. By using leverage to purchase a security, the portfolio is exposed to greater risks than with a traditional investment. In addition, leverage may lead to margin calls, requiring the premature liquidation of investment positions. Similarly, a long-short strategy may result in higher losses if both long and short exposures move in the same direction. Therefore, it is critical to understand the nature of risk associated with each investment.