Typically the risk of financial investments is associated with the measure of volatility, which means the variation of short term results compared with the long term average results.
The return achieved and the volatility are a good "summary" of the historical course of a security or of a portfolio. Though, they do not say anything about the reasons of a particular course neither on the alternative outcomes that the investment could have had. Traditional finance portfolio allocation models (Markovitz and Miller), through which are derived portfolios with the best combinations of risk and reward, are based on volatility measures.
Using returns and historical volatilities in order to optimize a portfolio is like driving by watching at the rear mirror. In order to build up a portfolio that meets the investor requirements under the highest number of future possible outcomes it is necessary to fully understand the drivers of the investment risk (Risk factors) and to ponder the exposure to it according to the desired time horizon.
Investments risk factors
There are various risk factors connected to investments. The main ones are:
The return achieved and the volatility are a good "summary" of the historical course of a security or of a portfolio. Though, they do not say anything about the reasons of a particular course neither on the alternative outcomes that the investment could have had. Traditional finance portfolio allocation models (Markovitz and Miller), through which are derived portfolios with the best combinations of risk and reward, are based on volatility measures.
Using returns and historical volatilities in order to optimize a portfolio is like driving by watching at the rear mirror. In order to build up a portfolio that meets the investor requirements under the highest number of future possible outcomes it is necessary to fully understand the drivers of the investment risk (Risk factors) and to ponder the exposure to it according to the desired time horizon.
Investments risk factors
There are various risk factors connected to investments. The main ones are:
- Rate Risk: the possibility that the future course of interest rates impacts negatively on the present value of the investment
- Share Risk: the possibility that the market value of a company decreases according to general events (systemic risk) or specific events related solely to the company (idiosyncratic risk)
- Credit Risk: the possibility that a debtor cannot be solvent or that the changed perception of his/her solvency reduces the value of the investment. We can distinguish between systemic and idiosyncratic risk also within the credit risk
- Exchange Risk: the possibility that the course of currencies impacts in a negative way on the value of the investments
- Liquidity: the possibility that some events occur as a result of which it is not possible to liquidate the investmen
- Correlation: the possibility that the correlations among various investments change suddenly with a negative impact on the portfolio
