Question

Answer in 200 words.

Explain the various sources of risk in an investment portfolio. In your opinion, what can an investor do to manage portfolio risk efficiently?

Answer 1

The various sources of risk affecting an investment portfolio is :

1. interest rate risk : bond prices move inversely to interest rate changes. The higher the interest rates, bond prices fall and lower interest rates leads to higher bond prices. Stocks are not much affected by changes in interest rates as the bonds are.
2. inflation risk: inflation reduces the fixed interest payments paid by the bonds. Inflation risk, leads to rising interest rates and purchasing power of dollars falls due to inflation.
3. market risk: common stocks are most affected by market risk. Market risks are wars, recessions, changes in the tastes and preferences of the consumers.
4. business risk:is the risk of conducting business in a particular segment or industry.
5. financial risk: taking debt in the business, exposes the company to financial risk. Risk that the financial difficulties that debt can put the company into, by failing to make the interest payments.
6. exchange rate risk: risk of the currency fluctuations on the payments to be made and to be received by the company.
7. country risk:it is the risk that an investor faces when investing internationally due to the political and economic instability of that country.

Investors can mange the risk effectively by following these steps:

1. Diversification: investors can reduce the risk in a portfolio by diversification. Diversification eliminate the unsystematic risk in a portfolio and exposes it only to market risk/systematic risk.
2. Investors can avoid investing in a portfolio by buying stocks on margin or buying on debt.
3. Investors can avoid significant risk by investing only in blue chip companies.
4. Investors can avoid investing in companies which have too much debt in their balance sheet and only invest in financially sound businesses.