Managing individual stock risk is one thing. Managing a portfolio — where the interactions between positions matter as much as the individual positions — is another entirely. Portfolio risk management uses a set of quantitative tools that let you see your actual total risk exposure, not just the sum of your individual positions.
When two assets have a correlation of +1, they move perfectly together — owning both gives you no diversification benefit. When correlation is 0, they're independent — owning both reduces portfolio volatility. When correlation is −1, they move perfectly opposite — owning both in equal weight gives you zero portfolio volatility.
The key insight: portfolio risk depends more on the correlations between assets than on the individual volatilities of those assets. Adding a volatile asset with low correlation to your existing portfolio can actually reduce total portfolio volatility.
The Sharpe ratio = (Portfolio return − Risk-free rate) ÷ Standard deviation. It measures return per unit of total volatility. A Sharpe above 1.0 is good; above 2.0 is excellent. Limitation: it penalises upside volatility the same as downside — winning big counts against you.
The Sortino ratio fixes this by using only downside standard deviation in the denominator. A strategy with frequent large gains and rare small losses will have a much higher Sortino than Sharpe. Most professional risk managers prefer Sortino for evaluating asymmetric return strategies.
Correlation warning — crisis changes everything: the correlation matrix above shows typical relationships. During severe market stress, correlations often move sharply toward +1 as investors sell everything for cash simultaneously. The 2022 experience — where bonds and equities both fell hard together — was unusual but not unprecedented. Diversification that works in calm markets can provide less protection in exactly the conditions where you need it most.
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