Quantifying Uncertainty and Risk

Reducing Portfolio Risk

The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions. 

Portfolio management requires 

• paying attention to the portfolio as a whole, 
• taking into account diversification, 
• possible hedging strategies, and 
• the management of portfolio cash flow. 

In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors.

Unlike return, risk is no more quantifiable at the end of an investment than it was at its beginning.

While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that.

Unlike return, however, risk is no more quantifiable at the end of an investment than it was at its beginning.

Risk simply cannot be described by a single number.  

Intuitively we understand that risk varies from investment to investment:  a government bond is not as risky as the stock of a high-technology company. But investments do not provide information about the risks the way food packages provide nutritional data.

Rather, risk is a perception in each investor's mind that results from analysis of the probability and amount of potential loss from an investment.

• If exploratory oil well proves to be a dry hole, it is called risky.  If a bond defaults or a stock plunges in price, they are called risky.  
• But if the well is a gusher, the bond matures on schedule, and the stock rallies strongly, can we say they weren't risky when the investment was made?  

Not at all.  The point is, in most cases no more is known about the risk of an investment after it is concluded than was known when it was made. 


There are only a few things investors can do to counteract risk:

• diversify adequately, 
• hedge when appropriate, and 
• invest with a margin of safety.  

It is precisely because we do not and cannot know all the risks of an investment that we strive to invest at a discount.  The bargain element helps to provide a cushion for when things go wrong.