Question 1

What is portfolio risk and how is it measured?

Accepted Answer

Portfolio risk measures the uncertainty of investment returns, typically quantified by volatility (standard deviation). It represents how much your portfolio value might fluctuate. A portfolio with 15% volatility might experience returns ranging from -15% to +15% around the average return in most years. Portfolio risk depends on: asset allocation, individual asset volatilities, and correlations between assets.

Question 2

How do you calculate portfolio volatility?

Accepted Answer

Portfolio volatility is calculated using: σp = √(w₁²σ₁² + w₂²σ₂² + 2w₁w₂σ₁σ₂ρ₁₂), where w = asset weights, σ = asset volatilities, and ρ = correlation. For a 60/40 stock/bond portfolio with 18% stock volatility, 6% bond volatility, and 0.2 correlation, the portfolio volatility is approximately 11.3%, demonstrating how diversification reduces risk below the weighted average of 13.2%.

Question 3

What is diversification benefit?

Accepted Answer

Diversification benefit is the risk reduction achieved by holding multiple uncorrelated assets. It's the difference between the weighted average of individual asset volatilities and the actual portfolio volatility. For example, if stocks (18% vol) and bonds (6% vol) are combined 60/40, the undiversified risk would be 13.2%, but the actual portfolio volatility might be only 11%, providing a 2.2% diversification benefit.

Question 4

What is the Sharpe Ratio and why is it important?

Accepted Answer

The Sharpe Ratio measures risk-adjusted returns: (Portfolio Return - Risk-Free Rate) / Portfolio Volatility. It shows how much excess return you earn per unit of risk. A Sharpe ratio above 1.0 is good, above 2.0 is very good, above 3.0 is excellent. For example, a portfolio returning 8% with 10% volatility and 2% risk-free rate has a Sharpe of 0.6, while one returning 10% with 12% volatility has a Sharpe of 0.67—the second is better risk-adjusted.

Question 5

What is correlation and how does it affect portfolio risk?

Accepted Answer

Correlation measures how two assets move together, ranging from -1 (perfect opposite) to +1 (perfect together). Lower or negative correlations provide better diversification. Stocks and bonds typically have 0.1-0.3 correlation (slightly positive), which helps reduce portfolio risk. Combining assets with 0 correlation cuts risk significantly; negative correlation provides even more diversification. This is why bonds traditionally diversify stock portfolios.

Question 6

What is an optimal asset allocation for risk management?

Accepted Answer

Optimal allocation depends on age, goals, and risk tolerance. Common guidelines: Age-based: 110 minus age in stocks (at 40, hold 70% stocks). Conservative: 40/60 stocks/bonds (low risk). Moderate: 60/40 stocks/bonds (balanced). Aggressive: 80/20 stocks/bonds (high growth). Very aggressive: 90/10+ stocks (maximum growth). Near-retirees: 30/50/20 stocks/bonds/cash. Adjust based on personal circumstances, time horizon, and market conditions.

Question 7

What is maximum drawdown and how is it calculated?

Accepted Answer

Maximum drawdown is the largest peak-to-trough decline in portfolio value. For stocks, it's often 2-3x annual volatility. A portfolio with 15% volatility might experience drawdowns of 30-45% during severe downturns (like 2008). Understanding max drawdown helps assess if you can emotionally handle losses. If 30% drawdown would cause panic selling, your portfolio is too risky. Estimate: Max Drawdown ≈ 2.5 × Portfolio Volatility.

Question 8

How does Modern Portfolio Theory relate to portfolio risk?

Accepted Answer

Modern Portfolio Theory (MPT), developed by Harry Markowitz, demonstrates that combining assets with low correlation reduces portfolio risk below weighted average risk. MPT introduced the efficient frontier—the set of portfolios offering maximum return for each risk level. Key insights: diversification is the only free lunch in finance, risk should be measured relative to the entire portfolio (not individual assets), and optimal portfolios maximize Sharpe ratio.

Question 9

How often should I rebalance to maintain target risk level?

Accepted Answer

Rebalancing frequency depends on strategy and costs. Annual rebalancing: sufficient for most investors, tax-efficient. Semi-annual: captures more opportunities. Quarterly: for active managers. Threshold-based: rebalance when allocation drifts 5%+ from target. Tax considerations: rebalance tax-advantaged accounts first to avoid capital gains. Studies show annual or 5% threshold rebalancing performs similarly with lower costs than frequent rebalancing.

Question 10

What are alternative assets and how do they affect portfolio risk?

Accepted Answer

Alternative assets (real estate, commodities, private equity, hedge funds) can improve diversification due to low correlation with stocks/bonds. Real estate (REITs): 0.4-0.6 stock correlation. Gold: -0.1 to 0.2 stock correlation (inflation hedge). Private equity: less liquid but potentially higher returns. Recommended allocation: 5-15% alternatives for diversification. However, alternatives often have higher fees, less liquidity, and require larger minimums—consider costs vs. benefits.

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