Where Does Portfolio Risk Come From?

 |  Includes: FXI, GLD, SPY
by: Marius Bausys

Most investors are well aware that their portfolio should be balanced in terms of risk. However, this fundamental concept of asset management gets frequently forgotten as people tend to focus on dollar amounts invested. When someone asks which asset classes you are invested in, only minority will answer this question with actual risk contributions rather than nominal amounts in mind. In fact, these would be two very different answers.

To highlight the distinction between dollar and risk allocations, let's assume an investor holds a portfolio of $100k, with 80% invested in stocks (NYSEARCA:SPY) and 20% in gold (NYSEARCA:GLD). At a first glance, it seems that roughly a fifth of the portfolio's risk should come from the investment in the gold ETF. However, a quick check on InvestSpy reveals that equities consistently accounted for more than 90% of portfolio risk across different time frames. Below are the figures for the last five year period:

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The 15% discrepancy between GLD's portfolio weight and risk contribution is primarily caused by the instrument's low correlation with SPY, which makes it an efficient diversifier. As a rule of thumb, the lower the correlation with the portfolio, the more likely a security is to have a lower risk contribution than its actual weight.

A similar notion applies when investors consider new positions for their portfolio. Building on the same example, let's assume our investor wants to add a 20% exposure to Chinese equities (NYSEARCA:FXI). In this case, an additional investment of $25k would be required to achieve the 20% dollar allocation to FXI, bringing the SPY weight to 64% and GLD to 16%.

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As seen in the table above, such an investment would in reality account for over 30% percent of the total portfolio risk due to FXI's relatively high volatility and correlation to SPY. Further analysis shows that only approximately 12% dollar allocation to FXI is required to achieve a 20% risk allocation to Chinese equities.

The hypothetical scenario described in this article illustrates the disparity between portfolio weights and risk contributions that often gets overlooked by investors. In order to better manage your portfolio, it is always advisable to check where its risk stems from.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.