Types of Portfolio Risks
What “Types of Portfolio Risks” Are There?
Investments are evaluated on the basis of several factors, including risk and return, which can be the key drivers in deciding what investments to make. Having stated this, there are various types of risks involved in making portfolio-related decisions. The major types of portfolio risks are loss of principal risk, sovereign risk, and purchasing power or “inflation”risk (i.e. the risk that inflation turns out to be higher than expected resulting in a lower real rate of return on an investor’s portfolio).
Key Learning Points
- There are various types of risk involved in creating investment portfolios
- Conservative investors are most concerned about the ‘loss of principal’ type of portfolio risk as they do not want to lose the original investment sum
- ‘Sovereign risk’ is most prominent in emerging markets, though it is applicable to every country
- ‘Purchasing power risk’ is most prominent in bonds and other types of fixed income securities
Loss of Principal – Risk
The loss of principal risk involves the chance that an investor may not get back the money he or she has invested, or may lose the value or at least a portion of the original investment made. Conservative investors are most concerned about this type of portfolio risk. Such investors value protecting the principal over seeking capital appreciation and prefer to accept lower returns for a higher degree of stability. Typically, a conservative investor seeks to minimize the loss of principal and risk.
Loss of principal risk is present in essentially all investments, except for an interest-bearing checking or savings account or a certificate of deposit.
This type of risk assesses the chance of a government or state going bankrupt or failing to make payments on its debt, or not honoring its loan agreements. This may be due to the country experiencing financial difficulties, due to which they are unable to honor their payments based upon agreed-upon terms of debt.
Sometimes this type of risk is due to governments refusing to honor their loan agreements. They can do this by easily altering their laws. This will cause adverse losses to investors who bought that country’s debt. Some examples of countries defaulting on payments to a large extent are Argentina and Mexico in the 1970s. The most recent example is Greece in 2015. An investor is exposed to sovereign risk, when investing in any country – though the risk is most prominent in emerging markets.
Rating agencies such as Standard and Poor’s, and Moody’s rate the quality of debt of all countries, which gives investors a measure of the sovereign risk involved.
Purchasing Power Risk
Purchasing power risk, widely known as “Inflation Risk,” is most prominent in bonds and other fixed-income securities.
This type of risk involves the chance that the cash flows from an investor’s investment will not be worth as much in the future, due to inflation. While inflation won’t generally affect an investor’s nominal return, assuming they hold the investment to maturity, it will impact their “real”rate of return. Due to inflation, the real rate of return can be lower than what was originally expected.
Importantly, the risk is not that there will be inflation, but the risk is that actual inflation will be higher than expected.
Fisher’s Equation – Inflation Risk and Real Rate of Return
Fisher’s Equation, used frequently to calculate return on investments – taking into account the effect of inflation – shows the relationship between nominal and real interest rates. One can use this equation to determine the real rate of return earned by an investor on his or her portfolio.
(1 + i) = (1+r) = (1+r) (1 + π)
Rearranging this formula, we get:
r = (1+i)/(1+ π) – 1
r = “real” rate of interest or real rate of return on portfolio investment
i = nominal interest rate
π = inflation rate
Inflation Risk and Real Rate of Return, Example
Given below is an example of how inflation risk lowers the real rate of return on an investor’s portfolio.
Suppose an investor in an emerging market economy has an investment portfolio (A). Last year, she earned a nominal return of 4.10% on her portfolio. However, her real return on the investment portfolio was 1.26%, given that last year’s inflation was 2.8% (scenario 1).
Now assume that inflation was much higher last year and turned out to be more than what investors expected (i.e. 3.2% – scenario 2 and 4% – scenario 3). Due to the inflation risk, this investor’s portfolio earned a much lower real rate of return of only 0.87% and 0.10% respectively.