A Complete Primer on Portfolio Risk Management in 2020

Risk management is a very important function in managing one’s mutual fund portfolio. Strong risk assessment and analysis practices go a long way in improving an investor’s risk adjusted returns.

What is covered in this article?

The Beginner’s Risk

For long, I managed my investment portfolio with a singular focus on returns and a mild understanding of risk.

I learnt some generic thumb-rules from colleagues, well-wishers and magazine articles. These were –

  1. Equity is risky,
  2. Debt is not risky and
  3. Higher the risk, higher the return.
High risk gets you higher returns and vice-versa
The bedrock principle of finance between risk and return. High risk gets you higher returns and vice-versa

One of the more common investment thumb-rules is – “Higher the Risk, Higher the Return”. I was educated in it and was the bedrock of my investments for a few years. It was true within good reason, afterall more returns required us to be taking greater risks.

We hear it so often in so many fields that it comes so naturally to us. Like in cricket, when a batsman goes down the pitch and hits a six, the commentators say “Oh! And the batsman take that extra risk to maximize the score in the powerplay”. We hear this in business where  entrepreneurs take massive risk to earn wild riches.

Successful & profitable investing requires a clear understanding of risk and return

What is the meaning of risk?

The classical definition of risk is the chance of making a loss.

In financial terms, risk is explained as the chance of an investment earning less than what it is expected to earn.

Modern practitioners have revised the definition of financial risk with a small yet significant difference. They define risk as the chance that the returns achieved on an investment will be different from the expected returns. The word “different” means risk not only has a downside risk but also an upside risk.

This financial understanding of risk is incredibly important and opens up profitable opportunities for us.

Risk is at the Core of Investing

Risk is at the core of investing and one cannot really make money without taking some risk. We often hear that government bonds are risk-free but that is not true. Even government issued instruments come with three types of risks –

  1. Interest rate risk,
  2. Inflation risk and
  3. Credit risk.

An example on credit risk points to Argentina who defaulted on its debt in 2001. Similarly, Mexico defaulted in 1994 amidst the Peso crisis. European countries like Russia defaulted in 1998, Iceland in 2008 and Greece in 2012. Even the United States (when they were independent states) defaulted in the 1840s.

Since one cannot avoid risk, a good investor embraces risk and uses risk to its advantage. What? Advantage of risk, you might be wondering. Yes! Let me explain.

Beginners often bracket risk in a very narrow definition which extends to the chance of loss of capital permanently. However smart investors understand that risk merely means volatility in the movement of the financial instruments. They understand that the movement can be both ways i.e upside or downside risk.

Good risks are different from bad risks. Bad risks are often a result of ignorance, overconfidence, inability to see the trends and a case of emotions over analysis
Good risks are different from bad risks. Bad risks are often a result of ignorance, overconfidence, inability to see the trends and a case of emotions over analysis

Opportunity often comes disguised as Upward Risk

Let’s understand this with a simple example.

You identify an asset (a house) whose true market value is ₹1,000,000. For the beginner investor, a drop of 10% in value to ₹900,000 triggers a fear. They think – “what if the price falls even further” to “what if the price falls to zero”. However the smart investor will use “risk” to fortify his position and purchase the house as it available at a 10% discount to the market value.

The smart investor understands the upward risk in the asset in the form that there is a strong chance of the asset appreciating in the near future.

Similarly, if the price of the asset were to increase by 10%, the beginner would feel more confident of purchasing the house. This is because he believes there is appreciation on the property although the data suggests that the house is overpriced by ₹100,000. While the beginner won’t pay ₹11 for a product worth ₹10, on this occasion he is more than happy to part with his money.

On the contrary, the smart investor identifies the risk of paying too much. He refrains from buying the house thereby saving himself from downward risk.

You really cannot make any significant money without taking some risk

However unnecessary, excessive or baseless risks can lead to peril for investors. There is nothing wrong with being risk-friendly or risk-averse, it just goes wildly wrong when the risk is mismanaged or reckless.

The objective of this post is to help you make risk your friend. This image will help you identify opportunities that you once saw as a misfortune.

I am reminded of Lee Janus’s words in the movie “Syriana”

When we write the GAAP rules like some kind of abstract painting .. stare at that liability hard enough and before long it’ll turn into an asset


What are the different types of financial risks?

There are 7 different types of financial risks –

  1. Asset-backed risk
  2. Credit risk
  3. Foreign Investment risk
  4. Currency risk
  5. Liquidity risk
  6. Stock Market risk
  7. Interest Rate risk

How to measure risk?

Risk is measured by using statistical measurements that are historical predictors of investment risk and volatility.

First, let’s spend some time in understanding the Modern Portfolio Theory

What is Modern Portfolio Theory?

Economist Harry Markowitz laid the foundations of the Modern Portfolio Theory which established the risk-return framework for investment decision-making. Modern Portfolio Theory offers investors a mathematical basis for selecting a portfolio of assets where the expected return is maximized for a given level of risk. The key insight of this theory was that an asset’s risk and return should not be assessed on it’s own. But it can be assessed by how it contributes to a portfolio’s overall risk and return.

The Modern Portfolio Theory assumes that investors are risk averse i.e. if two portfolios offer the same expected returns, the investor will prefer the less risky one. In other words, an investor will take additional risk only if there is compensation in the form of additional returns. Or — higher the risk, higher the return.

Let’s take an example here. United States government issued treasury bills offer 3% interest rates. We assume there is a zero chance of default in the United States government honouring the coupon (interest) on these bonds Since these bonds are offered by the world’s most stable & economically powerful country. Hence, we call these instruments – risk-free bonds – and the 3% as risk-free interest rate.

Now, if an investor were to be offered bonds of a different country like Mexico, the Modern Portfolio Theory requires that the investor needs to be offered an interest rate much higher than 3%. This is a key principle of the modern portfolio theory.

Principal Measures of Risk

The five principal risk measures are –

  1. Alpha
  2. Beta
  3. R-squared
  4. Standard deviation
  5. Sharpe ratio

Click on each of the links above to understand about each of the measures of risk in investing and finance with real-world examples. You will get deeper insights on how these statistics can be used to evaluate one financial instrument like a stock or mutual fund from another

How risk and return complement each other?

Risk and reward are a key part of investing. Investing carries a certain amount of risk which depending on how you look at it and what you do. This can range from little to excessive.

Understanding the relationship between risk and reward is tantamount to you building your personal investment structure.

Investment in instruments like stocks, bonds, gold, commodities, mutual funds, treasury bills, real estate or venture capital have their own risk profile. Understanding the differences of each can help you diversify and manage your portfolio better.

Risk-Return Tradeoff

The relationship between risk and return is the key of finance. The greater the potential return one seeks, the greater risk one generally assumes. This is reflected in the pricing of financial instruments where equity offers a better long-term return as compared to a bond. And as a result equity comes with a higher level of risk as compared to bonds.

This relationship between risk and return also guides the pricing of instruments in a free market. Stronger demand for a safe-instrument drives its price higher which comes more true if there is clear and present danger on the economic front like a war or oil price rise.

A turncoat happens often between equities and gold. In good times, investors show their muscle around equities and in bad times, cower behind the warmth offered by gold.

Growth in Gold prices and Stock Markets (Equities) generally have an inverse relationship
Growth in Gold prices and Stock Markets (Equities) generally have an inverse relationship

The appropriate risk-return tradeoff depends on a number of factors relevant to investors such as –

  1. Risk tolerance
  2. Years to retirement
  3. Potential to replace lost funds

Risk Tolerance

First, every investor has a different risk tolerance even within the same demographic profile. Some are comfortable with equities which can require a much longer time to show returns. And some others prefer the safety that bonds and savings accounts provide.

While we detest thumb-rules, all literature points towards younger men & women having  higher risk tolerance when compared to senior citizens. Younger people have a continuing stream of income from work which can compensate for delays or losses in performance from riskier assets like equities. This safety net is not generally available with senior citizens.

Popular financial investment options according to their potential return and risk
Popular financial investment options according to their potential return and risk

Years to Retirement

The more time the investor has to retire, the more time there will be for money. This time helps in a) compounding money into many multiples and b) live through periods of stagnant or negative returns.

This is a key criteria used in risk profiling as young users are encouraged to invest in more riskier assets while middle-aged and senior citizens are advised to exercise due caution by opting for a mix of equity and debt or sometimes only debt.

Ability to absorb losses

Finally, risk-return tradeoff also looks at an investor’s ability to absorb losses in the form of replacing it. If an investor is staking all life earnings then the asset advice will be very different than someone who has disposable money to invest. The condition of the investor will determine which kinds of assets can be offered which maintains the kind of risk-return profile that matches the investors current state.

Investment Risk and Return Characteristics

Different financial instruments hold a different risk-return signature. We have put forward some of the popular financial instruments and bucketed them in three bins –

  • High Return, High Risk
  • Moderate Return, Moderate Risk
  • Low Return, Low Risk

High Potential Returns – High Volatility – High Risk

Aggressive Growth-oriented mutual funds

These refer to mutual funds that invest in high PE stocks with high growth potential in rising industries. Axis Focused 25 Fund was one such mutual fund we had reviewed in this website. This aggressive growth fund is currently the most sought-after mutual fund in India.

Emerging markets mutual funds

Developing countries have rising economies when compared to stagnant GDP of developed countries. This allows developing countries to offer better return but carry additional risk. These risks can include their economy tanking & the dollar exchange rate going adverse.

Sectoral and precious metal mutual funds

Sectoral and commodities mutual funds are cyclical in nature. These come with heavy risk as their pricing is acutely subject to demand, supply and external factors including geo-political situations. Infrastructure Funds are influenced by demand-supply conditions and external factors like cost of raw materials and the availability of working capital from financial institutions.

Penny stocks

Penny stocks are small ticket or low priced stocks. These stocks tend to vacillate heavily on a daily basis and it is common to see these stocks go up & down by upto 20% in a single day

Small cap stocks and funds

Investing in small companies comes with many risks including management failures, losses, competition from larger players etc. However they can offer excellent returns but can also lead to spectacular losses.

Moderate Potential Returns – Moderate Volatility – Moderate Risk

Convertible bonds

A convertible bond is a type of bond that can be converted into a specified number of shares of common stock in the issuing company. As these bonds are issued by companies with low credit rating and high growth potential. The instrument comes with high risk and high return.

High-yield (Junk) bond funds

A high-yield bond (also called a junk bond) is a bond that is rated below investment grade. These bonds have a high risk of default of not just the coupon but also the principal. It comes as no surprise that they offer higher yields to make them attractive for investors.

In United States, there are mutual funds (like the Vanguard High Yield Corporate Fund Investor Shares (VWEHX) & BlackRock High Yield Bond Fund (BHYIX)) and even indices for high-yield bonds (like the S&P U.S. Issued High Yield Corporate Bond Index (SPUSCHY) and Citigroup US High-Yield Market Index).

Large-cap stocks and mutual funds

Large cap stocks represent companies listed on the stock exchange which have a pretty high market value (also called market capitalization). Companies with a market capitalization of ₹10,000 crores or more are large cap.

In the United States, large cap are companies with a market capitalization of $10 billion or more. Large cap companies are generally industry leaders with stable earnings, moderate growth, professional management and excellent brand name. Investment in large cap stocks or mutual funds will give you moderate returns at moderate risk.

Stock index funds

An index fund is a type of mutual fund where a portfolio is constructed to match a homogeneous set of stocks or criteria. In India, NIFTY50 tracked index funds are getting popular by the day. The NIFTY50 consists of the top 50 listed companies. Index funds provide broad market exposure, low operating expenses and low portfolio turnover.

Low Potential Returns – Low Volatility – Low Risk

Fixed annuities

A fixed annuity is an annuity contract that helps you accumulate wealth on a tax-deferred basis. Once the vesting period is over, a life insurance company will credit the annuity account with a guaranteed fixed interest rate. The life insurance company also guarantees the principal investment. The returns offered by these instruments is quite low since the life insurer guarantees the interest rate and principal. On the good side, annuity products absorb a lot of volatility and any risk of losing capital.

High quality short-and-intermediate-term municipal and corporate bonds

Local governments issued loans called municipal bonds. The interest paid by them on these bonds are usually tax-free. Corporations issued corporate bonds to raise money for ongoing operations, expanding business etc. They generally have a maturity of atleast one year.

Money market mutual funds

A money market fund invests in short-term debt securities which includes government issued treasury bills, commercial paper and debt instruments of a very short duration. These funds are generally regarded to be very safe. They offer higher returns than bank deposits.

How I lowered my portfolio risk to achieve higher returns?

Generally, risk and return have a positive correlation. A lower risk has a lower profit potential and a higher risk demands a higher return on investment. There is however, one important caveat – there is no guarantee that taking greater risk will actually results in a greater return. Infact on most occasions, we see that extremely high risk results results in loss of a larger amount of capital.

Strategy 1 – I treated all my investment decisions around the principle “Lower the Risk, Higher the Return”

I am convinced that a thumb rule like “higher risk leads to higher returns” is totally incorrect. This is especially true in cases where you have a huge opportunity to make a lot of money. It’s sort of an antithesis. We’ll examine this further but first, let’s run a scenario.

Example 1

You are the coach of the Indian cricket team and find your team down by 9 wickets. Your team needs to score 30 runs off 30 balls to win the match. As their coach, what would be your winning advice –

Option 1 : Score one run off every ball

Option 2 : Hit one six per over

There is no right or wrong answer at the moment. I have asked this question to over 300 participants and 75% of them have pointed to Option 1 i.e. score one run off every ball to reach the target of 30 runs in 30 balls.

Of these 75% .. 16% of the participants have moved from Option 1 to Option 2 when presented a visual of how they need to score

There is still no right or wrong answer because the selection is entirely based on the person’s perception. This is not enough because we need to develop a strategy for this match with additional information.

This additional information comes to us with who is going to bowl those 5 remaining overs. The bowlers are –

  • Jasprit Bumrah (currently ranked #1 in the ICC bowling charts)
  • Kedar Jadhav (part-time bowler)

Risk and Return on an XY Chart

Let’s plot this in a chart where the X-axis represents risk and the Y-axis represents returns.

Returns are the runs your batsman can score while Risk is the chance of them getting out or remain not out
Returns are the runs your batsman can score while Risk is the chance of them getting out or remain not out

Risk is either you get out or you remain not out. Return is you scoring a run or scoring a six.

If we were to place Jasprit Bumrah on this graph, few would disagree that the batsman has a higher chance of getting out to his bowling. It also happens that it will be most difficult to score a six off. They might just manage to wriggle out a run per ball when he is bowling. This will place Jasprit Bumrah in the bottom-left corner of the graph.

On the contrary, Kedar Jadhav is much easier to hit a six off. And is a lot more difficult to get out to. On the graph, Kedar Jadhav will be on the top-right.

Identifying Bumrah and Jadhav's bowling in a RISK and RETURN matrix
Identifying Bumrah and Jadhav’s bowling in a RISK and RETURN matrix

Which means –

  • In the case of Jasprit Bumrah, the risk is high (chance of getting out) while the return is low (scoring only one run). Or, higher the risk — lower the return
  • In the case of Kedar Jadhav, the risk is low (more likely to remain not out) while the return is high (chance of scoring a six). Or, lower the risk — higher the return

Inverse Theory of Risk and Return

So, in effect, this comes down to —

In case of Bumrah, you are taking a much higher risk for a potentially lower return. And the reverse is true in case of Jadhav where you have a much lower risk factor & a higher return potential.
In case of Bumrah, you are taking a much higher risk for a potentially lower return. And the reverse is true in case of Jadhav where you have a much lower risk factor & a higher return potential.

By boxing every situation into a thumb-rule, we fell that one has to take high risk to get high returns. This need not be the case. In the cricket example, my advice to the team would have been to play out Jasprit Bumrah’s overs and attack the 12 balls of Kedar Jadhav. If you get out to Kedar Jadhav, so be it. But still the risk-return tradeoff would be skewed to your advantage.

Come to think of it, we face a number of higher the risk, lower the return situations. Like when hiring an developer to join your product development team — the better the quality of the developer, the lower will be risk of delays, rework & buggy software. Here too we see the risk-return tradeoff to your advantage.

Example 2

Let’s see the lower the risk, higher the return in action with another example.

In a village fair, Ram and Shyam are two Kashmiri merchants who source cashmere sweaters. Cashmere sweaters are made from fibre from cashmere goats. These are finer, stronger, lighter and more insulating than sheep wool.

It so happens that Ram and Shyam source the sweaters from the same manufacturer in Pampore. Pampore is a town just outside of Srinagar in the state of Jammu & Kashmir in India. The Indian state is famous worldwide for its Saffron – the world’s most expensive spice.

The products sold by both merchants are exactly the same in all respects as they are from the same manufacturer. Ram prices his cashmere sweaters at ₹4,600 per unit while Shyam prices his sweaters at ₹6,200 per unit.  

Now Kabir, a local trader, visits the fair and concludes that he can make a killing with these cashmere sweaters. He reckons each of the sweaters can go for ₹10,000 per piece in a city like New Delhi. He was, ofcourse, surprised when he heard the differential prices quoted by Ram and Shyam.

Question 1 – where is the risk lower for Kabir?

You might start thinking of the answer by wondering what might be the risk. For starters, Ram or Shyam might be selling a product that does not qualify as cashmere wool (cashmere has very strict parameters like the width of the fibre should not exceed 19 microns). It is also possible that the merchants might take Kabir’s money and not deliver the product.

In course of this assessment, you would be wise to conclude that it is less riskier to lose ₹4,600 rather than losing ₹6,200 for the same product. Which means buying from Ram has the lower risk.

Question 2 – where is the return higher for Kabir?

Incidentally the returns are also higher for Kabir if he were to buy from Ram. That’s because he can make ₹5,400 of profit per piece (₹10,000 minus ₹4,600). This is about 45% higher than the ₹3,800 profit that Kabir would have made had he bought from Shyam.

And that’s yet another example of what we have been preaching. Lower the risk — higher the return

Strategy 2 – I weeded out redundant holdings

Using the right benchmark when comparing a mutual fund or stock or portfolio performance is important. For this purpose, statistical measures like Alpha, Beta, R-squared, Sharpe Ratio and Standard deviation are used often.

I put R-squared to great use as it helps me weed out redundant holdings and build a well-diversified portfolio. For example, when I applied R-squared to my portfolio, I saw a number of actively managed funds which had a high R-squared (92-95), beta close to 1 and an alpha of -0.4. This meant, fund managers were merely matching the benchmark in most respects and were not really picking stocks using value investing or contrarian strategies.

As a result, I replaced some of these active funds with large cap index funds. These index funds could give me similar or better performance at a much lower cost. That’s because the expenses of index funds are just 0.18% compared to actively managed funds which charge almost 1.50%. Using the R-squared together with alpha and beta can really help you understand your portfolio better.

Strategy 3 – I diversified on the basis of statistical measures

Another way in which I use R-squared investing is with my diversification strategy. A good diversification need not be only industry specific but statistics can also help.

I use stocks that have a low R-squared (between 30 and 60) to diversify. This ensure any potential jolts to the broader markets and indices will have less of an impact on my portfolio. Without the knowledge of R-squared, I might have merely diversifying with different industries while it was not improving my odds of cushioning the negative impact of a drastic change in index prices.

Strategy 4 – I followed a good asset allocation strategy

I use asset allocations to lower my risks without any compensation on returns. This is done around three key types of mutual funds – equity, bonds and equity arbitrage funds.

This is done is two steps –

  1. Deciding on how much to keep in equity and debt
  2. Of the equity, deciding on how much to keep in equity and equity arbitrage

Before we continue, let’s study a bit about arbitrage funds.

What are Equity Arbitrage Funds?

Equity arbitrage funds exploit the price differential between the cash and futures market to make money for investors. So, instead of purchasing stocks and later selling them at a profit (like how a regular equity mutual funds does) — an arbitrage fund buys stock in the cash market and simultaneously sells it in the futures market.

While the price differences in the spot and futures market are marginal, arbitrage funds execute an insanely large number of trades every year. This chips off pennies from each trade to make money for the investors. Currently, equity arbitrage mutual funds in India make around 7% returns per annum.

I use arbitrage funds in my portfolio because –

  1. As each stock is bought and sold simultaneously, arbitrage funds have very low risk
  2. Arbitrage funds are taxed as equity funds. This means you pay only 15% as short term capital gain and 10% as long term capital gain. The tax on long term capital gain is applied only if the gain is greater than ₹1,00,000. Had arbitrage been treated as a debt fund, then I would have paid 30% taxes on my gains.

The hitch I see with arbitrage funds are that they are not very reliable. Also, they are not very profitable during stable markets which, inspite of all the spot-futures differential, gives only mediocre returns.

Advantage of Arbitrage Funds

But I find one massive use for them.

I use arbitrage funds to park some of my investing money when I see that the stock market is extremely expensive. When the market corrects, I dip into these arbitrage funds and switch allocation from arbitrage to equity.

While there is no perfect formula for asset allocation, I follow a 60%:40% equity:debt rule which serves me best. The 60% is currently broken in 30% in equity and 30% in arbitrage. However there have been times when I have been 55% in equity aswell when the markets had corrected quite deeply in Feb 2016.

Strategy 5 – I rebalance my portfolio to reduce risk exposure

Rebalancing has tremendously reduced the risk in my portfolio and simultaneously boosted returns. I have been rebalancing my portfolio once a year for over five years now. This one practice has given me an additional 3-4% annual improvement in returns.

Here’s how you can rebalance your portfolio.

Say, you are starting out in January 2018 with ₹1,00,000 — and have decided on an model asset allocation of 60% equity, 30% debt and 10% gold.

Your portfolio in the beginning of the year, say 1st January 2018, are:

  • Equity : ₹60,000
  • Debt : ₹30,000
  • Gold : ₹10,000

Now, through 2018, the following changes happened to the asset classes.

  • Equity had an excellent year and grew by 20%
  • Debt had a poor year and grew by 6%
  • Gold was a disaster in 2018 and lost 16% of its value

As a result, your assets at the end of 2018, on 31st December 2018, will be valued at:

  • Equity : ₹72,000
  • Debt : ₹31,800
  • Gold : ₹8,400

Your portfolio on 31st December 2018 cumulates to ₹1,12,200. While this is good (12.2% return), your asset allocation has been disturbed. The current asset allocation now stands at:  

  • Equity : 64.2% (+4.2%)
  • Debt : 28.3% (-1.7%)
  • Gold : 7.5% (-2.5%)

How to re-allocate?

We need to bring this allocation back to 60%, 30% & 10% by the next day so that you can start 1st January 2019 with the model asset allocation on your ₹1,12,200 portfolio. The new allocation will be –

  • Equity : ₹67,320
  • Debt : ₹33,660
  • Gold : ₹11,220

Now that you have all calculations in place, do the following

  • Equity : Sell ₹4,680 (i.e. ₹67,320 minus ₹72,000)
  • Debt : Buy ₹1,860 (i.e. ₹33,600 minus ₹31,800)
  • Gold : Buy ₹2,820 (i.e. ₹11,220 minus ₹8,400)

This exercise not only helps in two ways –

  1. Rebalance your assets into a more comfortable apportionment
  2. Ensures you are not taking heavy risk in your portfolio by skewing your fortunes on the performance of a single asset.

Another school of thought says that while equity boosted up by 20% in the year, it is more likely that equity will not perform aswell in the next year. Thus by rebalancing, you have ensured that you are not staking a large portion of your portfolio on an asset which might not go up aswell as last year. By the same logic, the under-exposed asset class (gold, in our case) gets a chance to gain more for you.

Rebalancing is important as it removes emotion from decision-making. It is disciplined, systematic and unemotional just the way investing should be. Further, rebalance also maximizes your opportunity to earn more which reducing your risk.


This post is a bit long but captures the cohesiveness of risk and return. Risk can be your friend and it can be your enemy based on how you treat it. The best investors in the world embrace volatility in financial markets and have a strategy in place at times when the risk-reward equation is in their favour and when it not.

I was reading an interview by Tony Robbins, the well renowned peak performance expert, where he mentioned and emphasized on “asymmetric risk reward”. Per Robbins, the average person puts in a dollar and expects to make 10% or 20% if they get lucky. However the smart investor puts in a dollar expecting to make 5 dollars. This way even if the smart investor is wrong 80% of the times, he will still come out unscathed of his transactions as he would have still won his dollar back.

How true! Afterall … lower the risk, higher is the return!