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Part 4: Risk Management of an Investment Portfolio

by Patrick Oberhaensli, on Jan 20, 2020 2:44:00 PM


In the last part of our Risk Management of an Investment Portfolio series, we will discuss current human and strategic ways to address the risk management process. Finally, we will conclude our discussion by introducing risk-adjusted performance measures. We begin with the following detailed description of the three most important biases related to risk management.



Description from a risk perspective

Status quo

Not modifying the investment portfolio despite the change of market circumstances

This behavior often appears when equity markets fall down sharply. Instead of buying equities in order to keep the constant mix (the same percentage of equities after rebalancing), the investor stick to their previous stock position, hence the title status quo. In such a context, the risk of the portfolio is effectively smaller but the investor does not apply the predefined rebalancing approach. The ultimate risk is that at some point, the investor will sell all equities and… not enter the market again.


Overestimate of one’s competence in terms of investments

We often see this theme commonly discussed within the trading community. Overconfidence causes higher than necessary trading frequency (versus having a set strategy), often reflecting the volatility of the instrument traded.

This concept is important to consider not only at the operational level but also the strategy level.

Overconfidence can lead investors to develop a strategy that is unlikely to achieve their objectives – often happening with inexperienced traders. In a second step, when it becomes clear that the objectives cannot be met, the overconfident investor will still persist in keeping the positions running. This all occurs despite receiving constructive helpful advice from others to avoid excessive loss. This bias typically comes with narcissistic behavior.

Loss aversion

The fear of realizing losses out-weighs the potential of acquiring gains.

The discretionary portfolio manager wouldn't cut the losses, despite growing significantly, and on the other side quickly realize the gains.

One example of this can be seen when going passive at the individual market level. In this case, the investor would avoid loss aversion for specific stocks but not for the market.

But when examining a complete portfolio made up of multiple markets (invested passively), the lack of rebalancing rules in a disciplined manner could also result in a negative impact on the investments.


These human risk biases can be addressed, at least in part, with thorough education and psychological work. Several global non-for-profit organizations offer educational resources and when completed, investors can obtain a diploma in finance.

The Role of AI

Although Artificial intelligence (AI) is not, as of today, truly at the level of autonomous systems, it has been able to save lives and effectively support the “decision-maker” in certain situations. This happens through both assisting systems in rather simple situations and in medicine via precise and early/rapid recognition systems. It can also be of use in content filtering techniques. One of the key effects of AI (at least an expected one) is the reduction of costs

AI is another way we can address human biases and in the context of investment management, it can be integrated in trading, particularly in systematic approaches. Another angle when examining the possibilities of AI is robo-advisory, where there is a more or less high level of integration. Today, robo-advisors are essentially used for strategic rather than tactical asset allocation.

What investors need to consider, is that there are important limitations with AI: typically, there is a need for a large number of examples in order to “train” the AI and that’s not always a given. And the reality is often (much) more complex than expected: AI does not exactly work in the way humans intend.


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Risk-adjusted Performance Measures: An Introduction

The final risk evaluation aspect within portfolio management is the risk-adjusted performance measurement. We present the following short introduction to this theme.

The most common measure is the Sharpe Ratio, which is the ratio of the excess-return versus the (credit-)risk free interest rate against the standard deviation of the portfolio returns or their volatility. This basically assumes that there would be a normal distribution of returns but that’s certainly often not the case. To the contrary, we see with Sharpe Ratio that there is often a higher than expected frequency of large losses (even more so for longer term investment) in the markets.

The Information Ratio is less problematic (but still with issues) than the Sharpe Ration in that it brings the excess return of the portfolio versus the chosen benchmark in relation to the volatility/variability of that excess return. This excess return would be the risk, also called the Tracking Error or TE.


Risk management is an integral part of the investment process essential for achieving investment objectives. But it requires an adapted solution from the broker/ investment organization related to-the investor. The problematic nature of risk management is often under-addressed for different reasons, such as the typical human biases, despite the fact that it is well known that the implementation of proper systems do provide added value to a portfolio management. 

Written by: EVOLIDS FINANCE LLC, Disclaimer:

  • This content is not intended to be a solicitation nor an offer
  • The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible
Topic:Trading SignalsOnline Trading PlatformRobo-AdvisorIPSActive TradingRisk ManagementInvestment Strategy
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About this blog is a personal finance blog. The articles posted provide relevant trading information, aspects, and opinions from expert professional traders and data and analytics providers.

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