In Finance, Risk Is Best Judged in a Portfolio Context - Essay Example

? Portfolio Risk Assessment Individuals or companies invest their resources by purchasing various assets with hope of making gains from them when their market value goes above the purchasing price or from share of profits attained through trading activities (Engle 2009, p. 76). However, it is not always that the resources invested will realize a gain. There are many hazards associated with the resources invested; hence the resources invested may reduce in value below the original savings. Although many investors are aware that the value of their assets may decline over time, they have no capacity to predict the future of their savings in regard to whether they will experience a decrease or an increase in value (Sharpe 2007, p. 87). This uncertainty about future value of the assets makes it dangerous for the investors to put all their resources in a single investment opportunity no matter how lucrative it may seem to be. Therefore, it is preferable to spread resources in a collection of stocks as a precaution against total loss of investment due to unpredictable loss. Investors set their investment goals of maximizing their earnings and stabilizing their income from increase in value of their assets between the time of making investment and future period when they anticipate their portfolio to mature (Enrica 2012, p.123). However, the market is full of challenges that investors cannot predict at the time they are making investment. These challenges threaten to thwart investors’ objectives if increasing the value of their assets. Therefore, investors should be cautious in order to avoid losing all of their resources. Some of the risks the investors face in the market include: Liquidity risk, a type of risk that occurs in the event that assets can neither be sold nor bought faster enough to realize the perceived profit or to avert the anticipated decline in its market value (Connor, Goldberg and Robert 2010, p. 187). This scenario may occur when there are no potential buyers for such assets in the market at the current value to enable the owner to make a gain from sale of the assets. Credit risk: this is the risk due to the fact that most of the borrowers may fail to clear their debts in time as the lender had anticipated (Engle 2009, p. 81). Borrowers are required to repay the amount borrowed and some interest within specific period. However, in most cases borrowers fail to meet their targets hence resulting to the decrease in lenders’ earnings as a result of bad debts and expenses incurred when collecting the debts. Foreign investment risk: this is the risk due to the changes in market conditions across different countries that cause the decline in value of transaction in relation to another country (Sharpe 2007, 104). For example, different currencies have different exchange value across the globe. Similarly, different countries have adopted different accounting procedures in relation to depreciation of assets, stock valuation and so on (Cochrane 2009, p. 323). Therefore, depending on the approach used in the countries involved, international investors will obtain different earning from equivalent value of resources invested. Market risk: This is the probability that the value of the asset portfolio may reduce in value as a result of various aspects affecting demand and supply of that asset (Sharpe 2007, p.111). For example, the nature of market will result to either increase or decrease in value at which the assets are traded in the market. This is whereby the increase in supply of trade commodities results in the decrease of value of those commodities while the decrease in supply followed by the increase in purchasers’ demand will result in the increase in significance for those commodities (Constantinides, Harris, & Stulz 2003, p.301). Operational risk: Different companies or businesses perform better than others though in the same industry due to a number of factors (Connor, Goldberg and Robert 2010, p. 192). For example, some personnel are more qualified than the other hence this will increase efficiency of operation by cutting down operation cost and increasing the output per unit of the invested portfolio. On the other hand, some companies carry out thorough research in order to improve their efficiency by use of modern technology. This results in efficiency of performance hence decline in perceived risk (Enrica 2012, p. 13). Therefore, the companies or businesses using outdated technology, improper equipment or unqualified personnel are likely to experience a decline in earnings due to higher operation cost and low resource output. Some assets are perceived to be riskier than others due to the fact that different factors affect different assets either in the same industry or in different industries (Brunnermeier 2001, 142). For example, firms in agriculture industry are riskier than those in technology industries due to vagaries of weather and the perishability nature of agriculture commodities. Therefore, most people will prefer investing in less risky assets or industries regardless of the potential for greater earnings in riskier industries (Cochrane 2009, p. 352). The riskier assets are the greater the anticipated earnings while more stable assets usually yield lower returns. Financial risk is therefore better assessed in portfolio than in an individual stock or asset because different assets have different risks that are not necessarily caused by same factors (Engle 2009, p. 88). Therefore, investors have to analyse different risks associated with specific stocks before making investment decisions. However, investors can never be certain of the market outcome of the investments due to unpredictable circumstances. Furthermore, in Constantinides, Harris & Stulz (2003, p. 276), most investors fear taking risk and would therefore invest in stocks with low gain, but less risky rather than invest in riskier stocks with greater perceived earnings. Since it is not easy for investors to determine with certainty specific stocks that will yield greater returns and that are less risky, it is essential to spread the risk by investing their resources in a collection of assets (Enrica 2012, p. 14). This is important because it is not possible for all assets in a portfolio to suffer the same fate within the same period. However, it is always advisable to select stocks from different industries because some peril may affect the entire industry. Stocks in a portfolio should not have potential to affect each other such that a loss in one stock results to a loss on another stock in the same market. Risks associated with specific asset in a portfolio are referred to as unsystematic or specific risk (Engle 2009, p. 95). Therefore, holding different assets or investing in a portfolio will enable an investor to reduce this form of risk by spreading the perceived risk across a number of assets. In this situation, the risk is reduced due to the fact that when the earnings of one stock or asset in a portfolio declines, the sustained loss is offset by the gains in one or more stocks in the same portfolio (Lengwiler 2004, p. 197). Systematic risk, also known as Portfolio risk, or market risk, is caused by factors which affect all stocks in the market in a given period (Engle 2009, p. 94). For example, when there is an economic downturn, the value of all assets will hike hence affecting the investment portfolio regardless of the industry individual assets belongs to. Similarly, natural calamities like earthquake will affect all assets (Cochrane 2009, p. 367). The other factors such as government regulations in a given country will influence performance of all stocks in a given portfolio. Systematic risk cannot be minimized by investing resources across many stocks. This is because portfolio risks cause impact on all assets or stocks in the market regardless of the nature of individual assets in the portfolio (Brunnermeier 2001, p. 195). Investors are therefore interested in purchasing stocks that will help to minimize the systematic risk. This makes portfolio risk essential for investors when assessing the investment opportunities. The investors will evaluate the probability risk related to individual stock before including it in a portfolio (Lengwiler 2004, p.243). Since the risk associated with some single asset in portfolio can be spread by investing assets in different stock, investing in a portfolio becomes essential if each individual asset contribute to minimization of the risk related to the portfolio (Connor, Goldberg and Robert 2010, p183). It is due to this fact that the portfolio risk is essential in determining the nature of stock ones intends to purchase. For the investors in order to achieve their investment goals, they should understand the risk associated with each asset and plan on how to maximize their returns (Brunnermeier 2001, p.234). In addition, they should assess their potential to withstand ups and downs of their invested resources. Therefore, those who have high potential to withstand greater loss should focus on the stocks that have potential for higher gains though they are generally riskier in nature (Enrica 2012, p. 15). In conclusion, the investor’s goal is to boost the value of their assets by reducing risks as much as possible. There are various factors that cause reduction to the expected returns from the investments. However, investors cannot predict the exact gains or risk with precision at the time of making investment. It is for this reason that they have to select assets from various industries and different companies in order to spread the risk of their investment. This is based on the fact that different assets held in a portfolio cannot face the same risk in a given period. Assessing risk associated with a collection of assets instead of considering a single asset is the best approach to enable investors select more rewarding investments portfolio. 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