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Risk Of Individual Securities ( Assets ) Vs. The Risk Of Portfolios
The variance of returns can be used as a measure of risk if we are evaluating the entire portfolio of investments that an investor has. However, if the investment under consideration is meant to be an addition to an existing portfolio, then the variance of the asset return is not appropriate as a measure of risk of this investment. This is because we are interested primarily in the risk of our entire portfolio, and as far as this new asset is concerned, we would be interested in the incremental risk of the investment. The appropriate measure of the incremental risk of an investment differs from the variance, which is a measure of the total risk of the investment.
Consequently, we need to investigate how the variance of a portfolio is affected by the addition of a single asset. First, we need to define a portfolio in a more formal manner, and see how its variance is related to the variances of the assets that make up the portfolio.
The result that the risk of an individual asset in a portfolio is measured by the covariance of its returns with the portfolio returns is a useful one. However, according to this analysis, the measure of riskiness of a given asset is specific to the individual; hence this risk measure could differ from one person to another.
On the other hand, the market will not necessarily compensate each individual to the extent of the risk that s/he happens to bear on a given asset. As we saw before, it is possible to reduce portfolio variance through diversification. The market will be willing to compensate investors only for the risk that must be borne. We have to take equilibrium considerations into account to determine the nature of the asset risk that the market will actually compensate.
If we consider the economy as a whole, all the assets in the market must be held. Hence the market as a whole must bear the total risk, i.e. the variance of the return on the portfolio of all assets in the economy, which we term the market portfolio. The appropriate measure of risk of an individual asset, then, is the marginal contribution of that asset to the variance of the market portfolio.
Since we have already derived that the marginal contribution of an asset to the variance of a portfolio is the covariance of the return on that asset with the return on the portfolio, we see that im = Cov(Ri, Rm) measures the riskiness of an individual asset. The risk measure that is used in practice is this covariance normalized by the total variance of the market portfolio, which works fine if we are interested in the risk of an asset, relative to other assets.
Wise investors don’t put all their eggs into just one basket: They reduce their risk by diversification. They are therefore interested in the effect that each stock will have on the risk of their portfolio.
The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio.
I agree to what has been mentioned yet, and could not give more as this is not my primary focus of my specialties. Thanks for the invitation and thanks for giving me the opportunity to learn.
Read the following article & you shall know:
Make Your Portfolio Safer With Risky Investments
The risk of an entire investment portfolio is always less than the sum of the risks of its individual parts. Many investors lose sight of that fact when making investment decisions. When adding an additional security to your portfolio, you might look at the risk of the additional security only, not at its ability to reduce risk overall. In this article we'll explain how you can make your portfolio safer by adding risky investments.
Reduce Risk By Incorporating Risky Strategies
Hedging Strategies
Shorting a stock is always considered a risky strategy. You can, at best, make a100% return on the position if the stock declines to zero. In theory, the losses are infinite if the stock continues to rise. For example if you shorted a $10 stock and it climbed to $50 you would lose five times your original investment.
Similarly, buying a leveraged inverse ETF is also risky. For example, the ProShares UltraShort S&P500 ETF aims to provide performance, which is the inverse of, and double that of the Standard & Poor's500 Index (S&P500). So if the S&P500 rises by1%, the leveraged inverse ETF should fall by2%; and if the S&P500 falls by1%, the inverse ETF should rise by2%.
The above strategies would be considered risky, but if done properly in a portfolio context, you can reduce your risk instead of increasing it. For example, if you hold a large position in a stock that you cannot sell, by shorting the same stock in an equal amount, you have effectively sold the position and reduced your risk of the stock to zero. Similarly an investor with a portfolio of U.S. stocks can reduce their risk by buying the appropriate leveraged inverse ETF. A100% hedge will insulate you from risk, but it will also effectively reduce your exposure to any upside. (For further reading, see Inverse ETFs Can Lift A Falling Portfolio.)
Buying Insurance With Options
A put option is a risky investment that gives you the right to sell a stock or an index at a predetermined price by a specified time. Buying a put option is a bearish strategy because you believe the stock or the market will go down. You make money on a decline, and the most you can lose is the price you paid for the option. Given the leverage of an option, it would be considered a risky investment. However, when a put option is paired with a stock that you currently own, it provides protection against a lower stock price. Unlike hedging, which limits your upside, buying a put would still provide you with unlimited upside. It is, in effect, like buying insurance on your stock, and the cost of your put option is the insurance premium. (To learn the risks and how they can affect you on either side of an options trade, see Options Hazards That Can Bruise Your Portfolio.)
Using Low-Correlation Assets
A portfolio consisting mostly of bank stocks and utilities are considered relatively safe, whereas gold and gold stocks are generally considered risky. However, buying gold stock rather than another financial stock might in fact lower the risk of the portfolio as a whole. Gold and gold stocks typically have a low correlation with interest-sensitive stocks and, at times, the correlation is even negative. Buying riskier assets with a low correlation with each other is the classic diversification strategy. (For more insight, read Introduction To Diversification.)
Reducing Benchmark Or Active Risk
Which is considered the riskier portfolio: one that contains100% U.S.Treasury bills (T-bills) or one that has80% equity and20% bonds? In absolute terms, T-bills are the definition of risk-free investment. However, an investor might have a long-term asset mix of60% equity and40% bonds as their benchmark. In that case, compared to their benchmark, a portfolio containing80% equity will have less risk than one with100% U.S. Treasury bills. For the investor who has all cash, they can reduce their risk relative to their long-term benchmark by purchasing the risky equity.
The risk that your investment will not match that of your benchmark is called tracking error or active risk. The greater the difference in performance between the two, the greater the active risk or tracking error. One of the attractive features of index funds and ETFs is that they are meant to replicate benchmarks, thus reducing the tracking error to almost zero. Buying an ETF that matches your benchmark is always considered a safer investment than an actively managed mutual fund, from the perspective of benchmark or active risk. (To learn how to size up your portfolio manager, read Active Share Measures Active Management.)
Understanding Your Real Risks
Many investors consider doing nothing a less-risky strategy than making a decision. However, as John F. Kennedy said, "There are risks and costs to a program of action, but they are far less than the long-range risks and costs of comfortable inaction." A safe investment portfolio of all cash will allow you to sleep at night, but can be considered a risky strategy if it falls short of meeting your objective.
In the long run, safe investments like bonds and cash will never protect an investor against the risk of inflation. Only by purchasing riskier investments like equities, commodities or real estate can an investor provide the protection they need against losing the purchasing power of their assets. In the long run, a portfolio of all safe investments will turn out to be too risky for protection against inflation.
Consider an American couple who lived in the U.S. all their lives, and then moved to Canada to retire. All the investments were left to be managed in a diversified portfolio of U.S. securities. Currently, all their expenses are in Canadian dollars. They now have exposure to a weak U.S. dollar. By investing some of their assets in "riskier" Canadian securities, or by hedging the U.S. dollar with currency futures, they are providing protection against a weak dollar and making their portfolio safer.
Conclusion
Many investors look only at the risk of their individual securities, not at the combined effect on their portfolio. In fact, portfolios can be made safer by investment strategies that by themselves might be risky, but that in the context of the portfolio make it safer. This is especially true when confronted with the "real" risks that investors face long-term, such as inflation.
To learn how to balance your risks, read Measuring And Managing Investment Risk.
I am with the opinion of my brother FETAH MOHAMED
Composition of investment portfolios in stocks and bonds depends on the philosophy of the individual and the extent of his willingness to accept risk, as well as its own needs whether primarily aims to get a steady cash flow and periodically (monthly, quarterly or yearly) or that it aims to maximize profits.
Agreed with both answers given by Mr.:Vrindavan & Mr.:Siddiqui too
I am agree with Krishna Moorthy answer.
I think it would depend on the size of security and the size of portfolio
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