Courage with a Method: Why Returns Cannot Exist Without Risk

In investing, all risks can be divided into two categories: systematic and unsystematic risk.

Systematic risk, also known as market risk, affects all investments within a given asset class or even the entire market. It arises from external factors such as economic cycles, interest rate changes, inflation, geopolitical crises, natural disasters, or structural changes in the financial system. This risk cannot be eliminated through diversification within an asset class.

Unsystematic risk, also referred to as specific or idiosyncratic risk, affects individual companies, issuers, or sectors. It results from internal factors such as management errors, failed products, company-specific scandals, legal disputes, or sector-specific structural change. Unlike systematic risk, unsystematic risk can be significantly reduced — or largely eliminated — through diversification.

For investors, it is important to note that capital markets only reward systematic risk with a risk premium, as this risk is unavoidable. Unsystematic risk can and should be reduced through intelligent portfolio construction and is not compensated with additional returns.

Systematic risk is commonly measured using the beta factor, which indicates how strongly a portfolio reacts to market movements. A beta of 1.0 means the portfolio fluctuates in line with the overall market. A beta above 1.0 signals higher market sensitivity, while a beta below 1.0 indicates lower sensitivity.

The following sections describe the most important types of risk in portfolio management, addressing the questions: What is the risk? Is it primarily systematic or unsystematic? How is it measured and managed?

Market risk describes the danger that the value of investments fluctuates due to general market movements — for example, falling equity markets, rising interest rates, currency movements, or collapsing commodity prices. It represents the core of systematic risk and, in a multi-asset fund, primarily affects equities, bonds, and commodities.

Market risk is measured mainly through volatility and downside risk metrics. The key measure is volatility, which reflects the statistical dispersion of returns. Additional measures include Value-at-Risk (VaR) and Expected Shortfall, which indicate potential losses over a given time horizon at a defined probability level. Historical and hypothetical stress tests simulate how the portfolio would have behaved during crisis scenarios such as financial crises, interest rate shocks, or geopolitical escalations. Betas and correlations to benchmark indices are also analyzed to assess how strongly the portfolio reacts to market movements and how its components interact.

Market risk in a multi-asset fund is primarily managed through asset allocation. Equity exposure, average bond duration, allocations to higher-risk segments (e.g. high yield, emerging markets), and currency structure all influence the portfolio’s sensitivity to market events. In favorable environments, market risk may be increased within defined limits. In stressed markets, it is reduced through lower net equity exposure, shorter durations, reallocations into high-quality bonds or defensive sectors. Equity index or interest rate derivatives may also be used for temporary hedging without fully changing the strategic positioning.

Credit and issuer risk refers to the danger that borrowers — whether sovereigns, companies, or financial institutions — fail to meet interest or principal payments as agreed. This risk has both systematic and unsystematic components. It is systematic during broad economic or financial crises affecting many issuers simultaneously, and unsystematic when a single issuer defaults due to specific issues. In a multi-asset fund, this risk primarily affects corporate and government bonds. In addition to price losses, actual defaults or restructurings may result in permanent losses.

These risks are measured using external and internal ratings, default probabilities, loss-given-default assumptions, and market indicators such as credit spreads or CDS spreads. These inputs feed into credit models that continuously assess issuer quality. On a portfolio level, the effects of rating distributions, spread volatility, and correlations are analyzed. Stress scenarios involving multiple downgrades or sharp spread widening are also examined.

Credit and issuer risks are managed through strict diversification and clear limits per issuer, rating class, sector, and country. This prevents individual issuers or segments from dominating overall risk and effectively reduces unsystematic risk. Within these limits, sufficient credit quality is maintained, while higher-risk segments such as high-yield or subordinated bonds are used deliberately and in moderation. Significant changes in ratings, spreads, or internal credit assessments may trigger reductions, sales, or reallocations into more robust issuers.

Liquidity risk means that securities may be valued in theory but, in practice, can only be sold at significant discounts — or not at all — during certain periods. This risk has both systematic and unsystematic characteristics: it is systematic during market crises when liquidity dries up broadly, and unsystematic for individual thinly traded securities. For investors, liquidity risk is critical, as a fund must always be able to meet redemptions without damaging the portfolio through forced sales.

Liquidity is measured using bid–ask spreads, daily trading volumes, order book depth, and estimates of how long it would take to unwind certain position sizes.

Liquidity risk is managed through disciplined security selection, ensuring that underlying liquidity matches the fund’s liquidity requirements. If conditions deteriorate, illiquid positions must be reduced gradually before acute stress situations arise.

Concentration risk arises when a portfolio is overly focused on a small number of securities, sectors, countries, or themes. This risk is primarily unsystematic and results from insufficient diversification. In a multi-asset fund, it can occur within asset classes (e.g. equities concentrated in technology stocks) or across asset classes (e.g. high exposure to one country via equities, bonds, and currencies).

Concentration risk is first measured structurally through weights: the shares of the largest positions, issuers, sectors, countries, or themes are monitored and compared with predefined limits. Additionally, risk contribution analyses identify how much individual positions, sectors, or regions contribute to total portfolio risk. This helps uncover seemingly small positions that nevertheless pose significant risk due to high volatility and correlations.

Concentration risk is managed through clear diversification rules and active reallocation. Maximum position sizes and allocation ranges are defined for sectors, regions, and themes. Escalation measures include reallocations and targeted investments in asset classes or segments with low correlations to the existing portfolio, thereby actively reducing unsystematic risk.

Currency risk arises when investments are made in currencies other than the fund’s reference currency. For example, if the euro appreciates against the US dollar, a US equity may lose value in euro terms despite stable or rising local prices. Currency risk has both systematic components (e.g. global interest rate differentials, macroeconomic trends) and unsystematic components (e.g. country-specific events). In a globally invested multi-asset fund, currency risk is therefore an integral part of the return and risk profile. While foreign currencies add volatility, they also provide diversification and potential return enhancement.

Currency risk is measured by identifying open currency exposures and linking them to historical volatilities and correlations with the base currency. This allows the calculation of currency risk contributions to total portfolio volatility and Value-at-Risk. Scenario analyses — such as sharp appreciations or depreciations of specific currencies — help assess the impact on fund unit prices.

Currency risk is managed by deciding which exposures are deliberately retained and which are hedged, balancing diversification benefits against manageable volatility.

Inflation risk refers to the danger that the purchasing power of an investment declines because prices for goods and services rise faster than portfolio values. Since inflation is a macroeconomic phenomenon affecting all investors, this risk is systematic. A nominally positive return may therefore be negative in real terms after inflation.

Inflation risk is measured by comparing expected portfolio returns with current and expected inflation rates. Market-based indicators, such as breakeven inflation rates derived from nominal and inflation-linked bonds, help assess market inflation expectations.

Inflation risk is managed by incorporating inflation-sensitive assets into the allocation, such as inflation-linked bonds, real assets like equities, and selected commodities.

Operational risk arises from errors, inadequate processes, technical failures, or fraud — factors unrelated to market movements but still capable of causing losses. Regulatory risk results from changes in laws, tax rules, or supervisory requirements that may affect the investment universe, cost structures, or specific strategies. These risks are largely unsystematic and primarily relate to the internal organization and external environment of asset managers.

Such risks are not measured through market metrics, but via internal control and reporting systems, including incident and loss statistics, audit results, process reviews, and qualitative risk assessments. Regulatory risks are monitored through legal and compliance oversight, scenario analyses, and impact assessments of new regulations.

Operational and regulatory risks are managed through strict processes, clear responsibilities, segregation of duties, independent control functions, and continuous review of the legal framework. For investors, this means that beyond market expertise, the quality of organization, systems, and governance is crucial to reliable strategy execution.