RiskMetrics - Introducing RiskImpact
Understand how to measure the RiskImpact of your investments
RiskImpact measures how much risk a position contributes to the overall portfolio. Investors can use RiskImpact to identify concentration risks and preview the change in the portfolio's RiskGrade if a position were to be sold.
In the portfolio below, Yahoo! contributes a disproportionate amount of risk: its RiskImpact is 38%, even though its Market Value is only 20% of the portfolio's total value. It makes sense when we consider that Yahoo! is by far the most volatile stock, with a stand alone RiskGrade of 400. The next highest risk contribution comes from the Internet Fund (WWWFX): if we removed it, Portfolio RiskGrade would drop by 26%. On the other hand, GE and VFINX both help diversify the portfolio, as you can see by their relatively low RiskImpact.
How do we calculate RiskImpact? We basically take the difference between the RiskGrade of the portfolio with and without the position:
RiskImpact = Portfolio RiskGrade - Portfolio RiskGrade without position
To report RiskImpact as a percentage of the RiskGrade of the entire portfolio, we simply divide RiskImpact by the Portfolio RiskGrade.
RiskImpact is important because it shows how an individual position affects the overall portfolio risk. A relatively minor position could have a significant RiskImpact if it is (a) highly volatile, and (b) strongly correlated to the rest of the portfolio. In general, the less correlated an asset is to the rest of the portfolio, the lower its RiskImpact (and the greater the diversification benefit). Thus in the US sample portfolio above, adding another US stock would have a higher RiskImpact than adding a Japanese or European stock with a comparable RiskGrade.
By quantifying the marginal risk of each position, RiskImpact helps identify overconcentrations in particular assets or asset classes. Investors can use RiskImpact to analyze new transactions and to keep the portfolio balanced.