Investment Portfolio Risk

Last year, I wrote an article which introduced some of the ways in which investors misjudge risk management. I always meant to cover the topic in more detail but for one reason or another never got around to it. In today’s article, I want to take a more comprehensive look at investment portfolio risk management.

Investment portfolio risk comes in a few forms, but at its most basic is represented by the potential for permanent loss of capital. Loss of capital is caused by share prices declining; sometimes this is a result of poor timing in placing trades and sometimes by unforeseen market movements created by a response to new information. These losses can be manageable, in that a skilled investor can recover relatively easily, or can form a catastrophic loss that destroys such a significant portion of their capital that they cannot recover for many years (if ever).

As an investor, your job is to protect and grow your capital over time by sourcing and investing in assets which will appreciate in value. Despite this, I see a lot of retail investors focusing solely on this aspect of investing at the expense of risk management; pursuing capital gains by hiking their risk profile and dramatically increasing the potential for a catastrophic loss.

Portfolio Risk

In a typical portfolio, an investor will have three sources of capital.

  1. Cash – A fixed value source of capital with does not appreciate over time but instead decreases in value each year in line with inflation.
  2. Active Positions – Cash invested in positions (equities, bonds, options etc.), some of which will worth less than their original value.
  3. Profit – ‘Paper’ capital which is included within the overall value of the portfolio but is not ‘real’ until liquidated.

Successful investors are those which use the first source of capital to create the second and third, which they eventually extract to generate more of the first.

Many investors fail to recognise the value of the first source as most brokers pay zero percent interest, thus the position is becoming worth less each year it is not invested thanks to inflation. Because of this, many investors when first starting out ignore their cash position, trying to invest it as quickly as possible and holding extremely limited cash within their portfolio, viewing it as a dead weight compared to the second and third sources of capital.

The problem is that cash provides two benefits to an experienced investor which the amateur investor is now missing out on. Firstly, when a new investment opportunity arises, the investor must use cash to take a position, but due to their lack of cash they must extract it from either the second or third sources of capital.

This brings me to my first major investment portfolio risk;

Overinvesting in the Weakest Positions

When investors start out, they are usually extremely wary of volatility and emotionally incapable of withstanding even the most basic levels of volatility in their portfolios. Compared to a cash savings account, an investment portfolio will regularly have changes in value of 5-10% and will face drawdowns as severe as 50 or 60 %. As an investor, it’s your job to try to maximise profit, but not at the permanent loss of capital which will occur if you panic and sell when a position is down.

Having said this, I have met numerous retail investors who have a psychological aversion to selling at a loss. They expect to win on every trade they make and hold the perverse view that once they have selected a company as an investment that it simply HAS to become profitable eventually. As such, when faced with the need to extract capital to make a new investment, the investor often sells their top performers, which over time, cuts the legs of the leading investments and ensures that only those investments which are losing value and underperforming are held for the long-term.

In addition, these investors often anchor their investment’s value to their original buy price; consequently believing that if a position is reflecting a loss for them that it must  be better value than when they bought it.

Of course, the more experienced investor recognises that selling a position that is up 20% to invest in one that is down 20% to ‘rebalance’ will only work if the position that is in decline stops falling in value. Just because an investment is in your portfolio and is 20% down on your original buy price does not automatically make it a good trade!

Most investors believe that they are experts at what they are doing; even if they don’t phrase it in such a way, they at least believe themselves competent enough to be selecting investments and managing a portfolio. As such, once an investment is within their portfolio, they almost become blind to its flaws and convince themselves that now it is within the portfolio it will always be better value as long as it is held.

This is simply not true and brings me onto my second major investment portfolio risk.

Failing to Protect Capital

Over time, the retail investor begins to lose more and more money, overconcentrates their risk, often doubling down on their worst investments and creating a highly unbalanced portfolio with increased volatility. The increased volatility of the portfolio causes them to overconcentrate on the third source of capital, snatching at any profits they’ve generate, further concentrating their portfolio into the weakest positions and gradually destroying capital over time.

This is where many retail investors open themselves to the potential for catastrophic risk. Seeking to recover their losses, the investor ignores the importance of diversification and position sizing, allowing positions to represent 10%, 15%, or even 20% of their portfolio as they increase their opening position sizes in an attempt to make more profit and recover their earlier losses.

I run a portfolio of between 25-40 positions, which are spread across sectors, geographies, and company sizes. At worst, if a company goes bankrupt, I only stand to lose around 2.5-4% of my portfolio; easily recoverable. Of course, the way I run my portfolio means that I have a concentrated ‘top ten’ set of holdings, whereby I allow my top ten picks to collectively hold around 55% of my portfolio value (typically around 5% each but occasionally as high as 8%).

Consequently, these are some of my most carefully watched and most deeply researched investments but this diversification plays a huge role in protecting my capital. If some freak event happens (I’m looking at you COVID) and the potential for companies to collapse increases, I can still sleep easily knowing that my diversified portfolio is unlikely to be equally impacted. Some companies will continue to grow as others decline and even if three or four hit serious problems, I’m typically only risking around 10% of my capital.

By contrast, I’ve met dozens of retail investors who scoff when I talk about diversification but then end up calling me in a panic when three of their five positions have lost half their value and destroyed 60% of their capital.

There is of course, a third major investment portfolio risk which I’m yet to address; and this concerns the third source of capital.

Failing to Take Profits

I don’t mean to sound like all retail investors are bumbling fools that have no idea what they’re doing. After all, by any definition going, I am essentially one myself. Many retail investors manage to overcome the first two risks with practice and discipline, and as such, often face another risk when trying to deal with the third source of capital in their portfolio; profit.

In a portfolio worth £100,000, a good investor may hold 5-10% in cash, and have opened 30 positions of £2,500, worth a further £75,000. Thanks to capital appreciation, let us say that these positions have generated a 20% profit as a group, adding another £15,000 to the portfolio.



The question now becomes, what should the investor do with this profit. Any investor will tell you that market sentiment can change rapidly and be highly unpredictable. As such, this profit, until extracted back into cash is ‘at risk’. Skilled portfolio managers are able to judge the level at which take profit but view it in the same way as initial capital. Investing £100,000 and losing £15,000 on opening trades is essentially the same to having a portfolio with £15,000 of uncrystallised profits that are allowed to fade back into flat positions (or even worse, losses).

Remember; your job as investor is to maximise profit but there are two important caveats that come with this responsibility. Firstly, not every investment you make will be profitable. Secondly, you will not extract every possible penny of value from every investment you make.

A successful portfolio manager understands this and consequently both seeks managed losses as part of their portfolio management strategy and also seeks to extract profit in a controlled, systematic manner.