Unlocking Financial Data

Chapter 7. Portfolio Risk Analysis

Everyone has a plan ’til they get punched in the mouth.

Mike Tyson

This chapter covers three different techniques for measuring the risk and return of a portfolio of investments. First, we examine measuring risk by calculating the variance and standard deviation of a portfolio. Though this calculation might be complicated and requires matrix multiplication of correlation coefficients, it is a useful way to measure risk and the benefits of diversification. Moreover, you can use the portfolio standard deviation combined with expected return to calculate the portfolio’s Sharpe Ratio. The Sharpe Ratio is a traditional method for measuring the risk-adjusted return of a portfolio.

The second, and easier, technique to measure risk is breaking down the individual positions into different “buckets.” This technique can be useful in highlighting unseen concentrations and trends. For instance, by grouping positions into buckets by maturity, you can quickly determine the percentage of the portfolio that has near-term maturities. Some characteristics, such as ratings, might not be the focus of your investment decisions but can affect liquidity and price volatility.

The final technique is to establish thresholds for different metrics that can be easily monitored for breaches. For instance, this approach demonstrates how to highlight positions for which the price has moved significantly or is currently at the end of the 52-week range. It can also highlight ...