How to Quantify Risks When Building Your Perfect Portfolio
There’s no infinite money glitch in the real world—risk is an inherent part of investing, and you have to win some to lose some. Yet, although there’s no 100% secure way to invest, you can quantify risks to understand them better and make the right decisions. If you’d like to know how, just read on.
If it was possible to invest your money without any possibility of you losing it, you’d either have to pay a significant sum that reduced your returns, or the government would have to ban investing altogether. You can’t invest without taking on risk—but that doesn’t mean you should be unduly concerned about losing everything you have. If you manage and quantify risks instead of diving in recklessly, you can boost the chance of your portfolio showing positive returns.
Although risk quantification can get pretty technical, it’s a tool that every investor should have a basic understanding of. To get you to that point, we’ll explain what risk quantification is and how to get started yourself, so don’t go anywhere.
What is quantifying risks?
Quantifying risks is the process of identifying types of investment risks that may crop up during the investment process, then evaluating them to make decisions about how you’ll weight different assets (or exclude them altogether). This is all part of the process of boosting your chances of good returns.
Note that quantifying risks is different from qualitative risk analysis, which doesn’t involve attaching a numerical value to each risk. Risk quantification therefore makes it easier to make direct comparisons between different assets.
You need to quantify every single risk you could possibly encounter—for instance, it’s within the realm of possibilities that 80% of bitcoin owners could mysteriously lose access to their wallet, but this is so unlikely that it’s barely worth considering. Focus on the most pressing risks.
In other words, you’ll be considering the severity of risks: both the probability of an outcome happening and the impact that outcome would have.
Quantifying risks to make decisions
Whether you quantify risks or not, you’ll have to make investing decisions. If you want, you can make those choices blindly or based on vague notions of the risks involved (e.g., the stock market might crash, oil prices might go down, and governments may introduce regulations against cryptocurrency).
When you can attach a number to each of these possibilities, it’s far easier to make a decision. For instance, you might decide the likeliness of the stock market crashing soon is seven (out of ten) and the impact would be five. In comparison, the probability of governments introducing regulations against cryptocurrencies might be five, but the impact would be nine.
In this example, the severity of a stock market crash is 35, compared to a severity of 45 for mass cryptocurrency regulation. Cryptocurrency regulation is therefore a higher-risk investment (bear in mind we plucked these numbers out of thin air).
To make this analysis more tailored, an investor with a strategy tilted toward risk aversion may weight risk more than impact, and another might opt for more sophisticated statistical analysis techniques (which we’ll get into later).
Probability distributions and risk
One way to visualize the concept of risk quantification is to look at probability distributions, which are a way of seeing how likely various outcomes are. You’ve probably seen the diagram below before—it’s known as a normal distribution and is symmetrical. The y-axis (vertical) represents the probability of an outcome, and the x-axis (horizontal) is a measure of the outcome itself, like the percentage points a stock will change.
Because it’s symmetrical, it suggests moderate outcomes are more likely. In the example above, a stock is more likely to increase by 5% than by 50% (the far right of the distribution) or decrease by -50% (the far left of the distribution).
You might be thinking: “Hey, that’s not necessarily true.” Well, hang on a second—skewed distributions are also possible. In the diagram A below, an optimistic outcome is more likely, and in the diagram B below, a pessimistic outcome is more likely.
These diagrams aren’t just about showing off statistical prowess—they offer a visual aid that gives more meaning than just looking at the average returns or risks. The mean outcome in the three diagrams above might not be that drastically different, but you can see that outcomes overall are distributed very differently. This should affect the decisions you make for your portfolio.
How to quantify risks
Now, let’s pull everything together.
The primary aim of risk quantification is to maximize your returns while taking on the lowest amount of risk. You can achieve this by making the right asset allocation, diversifying, and rebalancing the portfolio as needed.
Part of this involves aiming for assets that aren’t correlated with each other. For example, investing solely in a mix of bitcoin and ethereum isn’t an effective method of diversification, because the two cryptocurrencies tend to move in the same direction. But investing in gold and the stock market would be, because gold tends to perform well when the stock market is struggling.
To make these kinds of decisions more precisely, institutional and retail investors quantify risks considering some of the measures outlined below.
Measures to consider
Firstly, it’s helpful to know how an asset compares to a benchmark—both in terms of its performance and volatility. The S&P 500 is a good benchmark since it contains many different companies and therefore represents a good average of the market in general. You can obtain coefficients that represent the performance (alpha) or volatility (beta) compared to a benchmark, and you can also analyze the extent to which performance correlates with a benchmark (R-Squared).
Ideally, you’d be looking for something that’s low in volatility and high in performance, although some investors might value one metric more than the other. To make this decision easier, you can buy an asset higher for being riskier, with the logic that investors should be compensated for taking on more risks. This is known as the capital asset pricing model.
Another factor to consider is variation—how much variation is there in the returns achieved? This measure represents volatility, and is often calculated as a standard deviation. However, standard deviations are derived from the assumption that a distribution is normal (remember the graphs we saw earlier?), so you should verify this assumption holds before using it.
A more advanced concept which is popular in financial analysis is the Sharpe ratio: a way of calculating whether a risk-to-reward tradeoff is worth it. This involves three calculation steps:
- Return of the portfolio minus risk-free rate (represented by any asset with minimum risk, like bonds)
- The standard deviation of the portfolio’s excess return (anything achieved beyond the risk-free rate)
- The result of step one divided by the result of step two
The higher the final number, the better the risk-to-reward profile, and anything over one is generally considered a good bet.
Investing with MyConstant
Whether you use the techniques outlined above, something simpler, or simply enlist a professional to invest for you, that’s your choice. We can’t quantify your risks, but we can point you in the direction of a few investments you might want to consider.
At MyConstant, we have a proud record of no investor losing their initial investment to date—yet you can earn up to 4% APY through depositing in our multi-crypto wallet or earn up to 7% APR by lending out your crypto to others. Now, that sounds like it has potential for a good risk-to-reward score.
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