Investing in stocks and funds: how to reduce portfolio risk?

Ways to minimize risk and optimize portfolio return in simple terms

For a long-term or medium-term investor, it does not make sense to reduce risk just like that, it needs to be optimized according to the needs of the investor himself. If the investor's long-term goal is the amount (value) of the portfolio, which can be achieved with an annual capital growth of 12-15% per annum, then the risk of the portfolio should be optimized for this expected return.

In fact, you need to minimize the risk under a given level of expected return. And this is the key concept of risk and return optimization, it is based on the assumption that the portfolio can have an optimal ratio of expected return and risk.

How are risk and return on investment related?

Risk and return are always linked, and therefore having risk in a portfolio means having some expected return. Another thing is how to manage this risk, how to regularly recalculate and thereby update the risk and expected return. If a company's stock has high upside potential, the stock will also have higher risk (market risk and unsystematic risk). Naturally, the portfolio risk structure and parameters will depend on market expectations and on the macroeconomic forecast for the next 6-12 months.

If the economy grows and develops, companies expand production, then, as a result, the profitability of the company will grow. Institutional investors who basically own 95% of all assets will seek to buy these assets into their portfolio.

And vice versa, if, according to analysts' forecasts, the economy will experience difficulties, then similar processes will be observed at the level of companies. The profitability of companies will decline, competition will intensify and, as a result, volatility will increase, and at some point in time, stocks will fall along with the market or faster than the market.

Hence the conclusion that risk and return are interconnected, that is, they correlate to some extent with the behavior of the S&P500 broad market index. It all depends on the particular company, its place in the value chain and its degree of risk, leverage, etc.

Types of risk in the investment portfolio (Beta, Standard Deviation)

In the world of investment, there are two main types of risk, this is market risk (systematic), which cannot be completely eliminated, and there is volatility (non-systematic risk Standard Deviation) - this is the company's or asset's own risk, which is expressed as the standard deviation of the asset price from its average. Such a deviation in the price of an asset can be either up or down.

Market risk is the Beta of an asset, which mainly depends on the correlation to the market and the company's leverage level. Companies with a high leverage generate higher ROE (return on equity) due to leverage during periods of economic growth. It all depends on the ratio, equity and debt capital of the company. But this is all with strong competitive advantages of the company.

What risk can be minimized through diversification?

Standard Deviation is an asset's own non-systematic risk, which mainly depends on the degree of volatility in the company's earnings. In fact, if a company is unstable in its profits, then the market reacts accordingly, sells or buys shares of this company, or speculates on these price fluctuations.

In other words, Standard Deviation is just a characteristic of the price of an asset, the asset can rise and fall, the price will fluctuate in both directions from its average, while the general trend in the price of the asset will be downward. This type of risk should be perceived as a parameter that can be worked with and minimized through proper portfolio diversification.

The long-term investor needs to remember that strategy is more important than time volatility. And if you have selected an asset in your long-term portfolio, then you need to keep it throughout the entire investment horizon. Of course, from time to time it is necessary to rebalance the portfolio, and bring the portfolio parameters to its strategic and target parameters. But rebalancing needs to be done properly, and under the supervision of a professional portfolio manager or investment strategist.

Is risk in an investor's portfolio good or bad?

For a systematic long-term investor, the risk in the portfolio is both good and bad at the same time, but basically it is a certain potential that needs to be used correctly. Everything will depend on the investor's tolerance for risk and the investment horizon. If an investor is 30-35 years old, and his long-term goal is expressed as the amount needed in 10-15 years, then the risk will not hurt, but rather it will be an advantage.

The portfolio of such an investor will be more aggressive and consist of growth companies, index funds and sectoral ETFs with a beta above the market. In any case, this is all very individual, and in life there are situations that require quick access to a part of the portfolio's assets. Therefore, it is better to set up and form such decisions and portfolio parameters together with a specialist in financial planning and investment portfolio management.

In general, it should be noted that for a large long-term investor, it is best not to experiment on your own, but to seek detailed investment advice from a professional investment advisor.

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Zair Iusupov is an investment architect, a specialist in building portfolio solutions for private investors, business owners, HNWI and UHNWI clients. He has expertise in the field of financial engineering, portfolio investment risk management, strategic asset allocation and development of individual investment solutions.

He specializes in developing portfolio strategies for investors with capital of $300K–$5M+, combining in-depth macroeconomic analysis, fundamental assessment of US and European companies, Strategic Asset Allocation, Investment Policy Statement, a quantitative approach to risk assessment and long-term investment discipline.

Zair Iusupov

Founder and Chief Investment Officer

Wealth Management and Private Advisory (US, EU)

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