quantwise 1.2.0 → 1.2.2

package/.claude/skills/portfolio-manager/references/portfolio-risk-metrics.md

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+# Portfolio Risk Metrics
+
+This document provides comprehensive guidance on measuring and interpreting portfolio risk using standard financial metrics.
+
+## Overview
+
+Portfolio risk assessment requires both quantitative metrics and qualitative judgment. This guide covers:
+
+1. Volatility-based metrics (standard deviation, beta)
+2. Downside risk measures (maximum drawdown, semi-deviation)
+3. Risk-adjusted return metrics (Sharpe ratio, Sortino ratio)
+4. Concentration and correlation metrics
+5. Interpretation frameworks for different investor types
+
+## Volatility Metrics
+
+### Standard Deviation (σ)
+
+**Definition:** Measure of how much returns vary from the average return over time.
+
+**Formula:**
+```
+σ = √[Σ(R_i - R_avg)² / (n-1)]
+
+Where:
+R_i = Return in period i
+R_avg = Average return
+n = Number of periods
+```
+
+**Interpretation:**
+
+| Annual Std Dev | Risk Level | Typical Assets |
+|---------------|------------|----------------|
+| **<5%** | Very Low | Cash, short-term bonds |
+| **5-10%** | Low | Bond portfolios, conservative balanced |
+| **10-15%** | Moderate | Balanced portfolios (60/40), dividend stocks |
+| **15-20%** | High | Stock portfolios, growth stocks |
+| **>20%** | Very High | Small caps, emerging markets, sector funds |
+
+**S&P 500 Historical:** ~15-18% annualized standard deviation
+
+**Usage in Portfolio Analysis:**
+- Compare portfolio volatility to benchmarks
+- Assess if volatility matches investor risk tolerance
+- Track changes in volatility over time (increasing volatility = warning sign)
+
+**Limitations:**
+- Assumes normal distribution (actual returns have "fat tails")
+- Treats upside and downside volatility equally
+- Based on historical data (may not predict future)
+
+### Beta (β)
+
+**Definition:** Measure of portfolio sensitivity to market movements.
+
+**Formula:**
+```
+β = Cov(R_portfolio, R_market) / Var(R_market)
+
+Or estimated as:
+β = (Σw_i × β_i)
+
+Where:
+w_i = Weight of position i
+β_i = Beta of position i
+```
+
+**Interpretation:**
+
+| Beta | Market Sensitivity | Portfolio Behavior |
+|------|-------------------|-------------------|
+| **β < 0.5** | Very low | Defensive, low correlation to market |
+| **β = 0.5-0.8** | Low | Below-market volatility, defensive tilt |
+| **β = 0.8-1.0** | Moderate | Slightly less volatile than market |
+| **β = 1.0** | Market | Moves in line with market (index-like) |
+| **β = 1.0-1.3** | Moderate-high | More volatile than market |
+| **β = 1.3-1.6** | High | Significantly more volatile |
+| **β > 1.6** | Very high | Extremely volatile, aggressive |
+
+**Typical Security Betas:**
+- Utilities: 0.4-0.7
+- Consumer Staples: 0.5-0.8
+- Healthcare: 0.8-1.1
+- S&P 500 Index: 1.0
+- Technology: 1.1-1.5
+- Small-cap growth: 1.3-2.0
+- Leveraged ETFs: 2.0-3.0
+
+**Example Portfolio Beta Calculation:**
+
+Portfolio:
+- 40% SPY (S&P 500 ETF, β=1.0): 0.40 × 1.0 = 0.40
+- 30% QQQ (Nasdaq ETF, β=1.2): 0.30 × 1.2 = 0.36
+- 20% VNQ (REIT ETF, β=0.9): 0.20 × 0.9 = 0.18
+- 10% TLT (Bond ETF, β=0.3): 0.10 × 0.3 = 0.03
+
+**Portfolio Beta** = 0.40 + 0.36 + 0.18 + 0.03 = **0.97**
+
+**Interpretation:** Portfolio expected to move 97% as much as the market (slightly defensive).
+
+**Usage:**
+- Assess portfolio aggressiveness
+- Predict portfolio behavior in market moves (β=1.2 means 12% drop when market drops 10%)
+- Identify need for hedging or rebalancing
+
+**Limitations:**
+- Beta changes over time
+- Based on historical correlations
+- May not hold in extreme markets
+
+### Semi-Deviation
+
+**Definition:** Standard deviation of returns below the mean (focuses on downside volatility only).
+
+**Formula:**
+```
+Semi-deviation = √[Σ(R_i - R_avg)² for all R_i < R_avg / n]
+```
+
+**Interpretation:**
+- Lower semi-deviation = better downside protection
+- Useful for risk-averse investors who care more about losses than gains
+- Typically 60-70% of standard deviation for symmetric distributions
+
+**Usage:**
+- Evaluate downside risk specifically
+- Compare defensive vs aggressive strategies
+- Input for Sortino ratio (risk-adjusted return metric)
+
+## Downside Risk Metrics
+
+### Maximum Drawdown (MDD)
+
+**Definition:** Largest peak-to-trough decline in portfolio value over a specific period.
+
+**Formula:**
+```
+MDD = (Trough Value - Peak Value) / Peak Value
+
+Or: MDD = max[(P_peak - P_trough) / P_peak] over all peaks
+```
+
+**Example:**
+- Portfolio peak: $150,000 (March 2020)
+- Portfolio trough: $105,000 (March 2020 crash)
+- MDD = ($105k - $150k) / $150k = **-30%**
+
+**Historical Maximum Drawdowns:**
+
+| Asset/Portfolio | Max Drawdown | Period |
+|----------------|--------------|--------|
+| S&P 500 | -57% | 2007-2009 (Financial Crisis) |
+| S&P 500 | -34% | 2020 (COVID Crash) |
+| Nasdaq 100 | -83% | 2000-2002 (Tech Bubble) |
+| Nasdaq 100 | -32% | 2021-2022 (Rate Hikes) |
+| 60/40 Portfolio | -32% | 2007-2009 |
+| Treasury Bonds | -48% | 2020-2023 (Rising Rates) |
+
+**Risk Tolerance Guide:**
+
+| Investor Type | Max Acceptable Drawdown |
+|--------------|------------------------|
+| **Conservative** | -10 to -15% |
+| **Moderate** | -15 to -25% |
+| **Growth** | -25 to -35% |
+| **Aggressive** | -35 to -50% |
+
+**Usage:**
+- Assess worst-case historical scenario
+- Compare to investor risk tolerance
+- Set risk management triggers (e.g., hedge if drawdown >20%)
+- Estimate recovery time needed
+
+**Recovery Time:**
+- 20% drawdown requires +25% gain to recover
+- 30% drawdown requires +43% gain
+- 50% drawdown requires +100% gain (doubling)
+
+### Current Drawdown
+
+**Definition:** Decline from most recent peak to current value.
+
+**Formula:**
+```
+Current Drawdown = (Current Value - Recent Peak Value) / Recent Peak Value
+```
+
+**Example:**
+- Recent peak: $150,000 (last month)
+- Current value: $142,500
+- Current drawdown = ($142.5k - $150k) / $150k = **-5%**
+
+**Interpretation:**
+
+| Current Drawdown | Status | Action |
+|-----------------|--------|--------|
+| **0%** | At all-time high | Monitor for complacency |
+| **-1% to -5%** | Minor pullback | Normal, no action |
+| **-5% to -10%** | Moderate correction | Review positions, monitor |
+| **-10% to -20%** | Correction | Assess portfolio, consider adjustments |
+| **>-20%** | Bear market territory | Review allocation, consider rebalancing |
+
+**Usage:**
+- Real-time risk monitoring
+- Identify when portfolio is under stress
+- Trigger rebalancing or risk reduction
+
+### Value at Risk (VaR)
+
+**Definition:** Maximum expected loss over a given time period at a given confidence level.
+
+**Example:**
+- 1-month VaR at 95% confidence = $10,000
+- **Interpretation:** 95% confident that portfolio will not lose more than $10,000 in the next month (or: 5% chance of losing more than $10,000)
+
+**Calculation Methods:**
+
+1. **Historical VaR:** Use historical return distribution
+2. **Parametric VaR:** Assume normal distribution, use mean and std dev
+3. **Monte Carlo VaR:** Simulate thousands of scenarios
+
+**Simplified Parametric VaR Formula:**
+```
+VaR = Portfolio Value × (z-score × σ - μ)
+
+Where:
+z-score = 1.65 for 95% confidence, 2.33 for 99% confidence
+σ = Portfolio standard deviation (daily or monthly)
+μ = Expected return (daily or monthly)
+```
+
+**Example Calculation:**
+- Portfolio value: $100,000
+- Annual std dev: 18%
+- Monthly std dev: 18% / √12 = 5.2%
+- Expected monthly return: 0.5%
+
+**95% 1-month VaR:**
+```
+VaR = $100,000 × (1.65 × 5.2% - 0.5%)
+    = $100,000 × (8.58% - 0.5%)
+    = $100,000 × 8.08%
+    = $8,080
+```
+
+**Interpretation:** 95% confident that portfolio will not lose more than $8,080 in the next month.
+
+**Usage:**
+- Risk budgeting
+- Setting position limits
+- Regulatory compliance (for institutions)
+
+**Limitations:**
+- Assumes historical patterns continue
+- Underestimates tail risk (extreme events)
+- Doesn't tell you about losses beyond VaR threshold
+
+## Risk-Adjusted Return Metrics
+
+### Sharpe Ratio
+
+**Definition:** Excess return per unit of risk (reward-to-variability ratio).
+
+**Formula:**
+```
+Sharpe Ratio = (R_portfolio - R_f) / σ_portfolio
+
+Where:
+R_portfolio = Portfolio return (annualized)
+R_f = Risk-free rate (typically 10-year Treasury)
+σ_portfolio = Portfolio standard deviation (annualized)
+```
+
+**Example Calculation:**
+- Portfolio return: 12%
+- Risk-free rate: 4%
+- Portfolio std dev: 15%
+
+**Sharpe = (12% - 4%) / 15% = 8% / 15% = 0.53**
+
+**Interpretation:**
+
+| Sharpe Ratio | Quality | Interpretation |
+|--------------|---------|----------------|
+| **< 0** | Poor | Return less than risk-free rate |
+| **0 - 0.5** | Suboptimal | Low excess return for risk taken |
+| **0.5 - 1.0** | Good | Adequate risk-adjusted return |
+| **1.0 - 2.0** | Very Good | Strong risk-adjusted return |
+| **> 2.0** | Excellent | Exceptional risk-adjusted return |
+
+**Typical Sharpe Ratios:**
+- S&P 500 (long-term): 0.3-0.5
+- Well-managed equity portfolio: 0.5-0.8
+- Exceptional hedge fund: 1.0-1.5
+- Market-neutral strategy: 1.5-2.0+
+
+**Usage:**
+- Compare different portfolios or strategies
+- Assess if additional risk is being compensated
+- Benchmark against market (S&P 500 Sharpe)
+
+**Limitations:**
+- Penalizes upside volatility equally with downside
+- Assumes normal distribution
+- Sensitive to time period chosen
+
+### Sortino Ratio
+
+**Definition:** Like Sharpe ratio, but uses downside deviation instead of total volatility.
+
+**Formula:**
+```
+Sortino Ratio = (R_portfolio - R_f) / Semi-deviation
+
+Where semi-deviation only counts returns below risk-free rate
+```
+
+**Example:**
+- Portfolio return: 12%
+- Risk-free rate: 4%
+- Semi-deviation (downside only): 10%
+
+**Sortino = (12% - 4%) / 10% = 0.80**
+
+**Interpretation:**
+- Higher Sortino = better downside-adjusted returns
+- Sortino typically higher than Sharpe (since semi-deviation < standard deviation)
+- Preferred metric for risk-averse investors
+
+**Usage:**
+- Evaluate strategies with asymmetric returns (e.g., option strategies)
+- Focus on downside protection
+- Compare portfolios with different return distributions
+
+### Calmar Ratio
+
+**Definition:** Return relative to maximum drawdown.
+
+**Formula:**
+```
+Calmar Ratio = Annualized Return / |Max Drawdown|
+```
+
+**Example:**
+- Annualized return: 10%
+- Max drawdown: -25%
+
+**Calmar = 10% / 25% = 0.40**
+
+**Interpretation:**
+
+| Calmar Ratio | Quality |
+|--------------|---------|
+| **< 0.5** | Poor (high drawdown relative to return) |
+| **0.5 - 1.0** | Acceptable |
+| **1.0 - 2.0** | Good |
+| **> 2.0** | Excellent (low drawdown, high return) |
+
+**Usage:**
+- Focus on worst-case scenarios
+- Evaluate hedge funds and absolute return strategies
+- Assess recovery potential
+
+## Concentration and Correlation Metrics
+
+### Concentration Metrics
+
+**1. Top-N Concentration**
+
+Percentage of portfolio in largest N positions:
+
+```
+Top-N % = (Σ Top N Position Values) / Total Portfolio Value
+```
+
+**Guidelines:**
+- Top 1 position: <10% ideal, <15% maximum
+- Top 5 positions: <40% ideal, <50% maximum
+- Top 10 positions: <60% ideal, <70% maximum
+
+**2. Herfindahl-Hirschman Index (HHI)**
+
+(See diversification-principles.md for detailed explanation)
+
+```
+HHI = Σ(Weight_i × 100)²
+```
+
+**Quick Assessment:**
+- HHI < 1000: Well-diversified
+- HHI 1000-1800: Moderately concentrated
+- HHI > 1800: High concentration
+
+### Correlation Metrics
+
+**Average Pairwise Correlation**
+
+Average correlation between all position pairs:
+
+```
+Avg Correlation = Σ(ρ_ij) / Number of pairs
+
+Where:
+ρ_ij = correlation between positions i and j
+Number of pairs = n(n-1)/2 for n positions
+```
+
+**Example (5 positions):**
+- 10 pairs total
+- Sum of correlations: 5.2
+- Average: 5.2 / 10 = **0.52**
+
+**Interpretation:**
+
+| Avg Correlation | Diversification Quality |
+|----------------|------------------------|
+| **< 0.3** | Excellent (low correlation) |
+| **0.3 - 0.5** | Good |
+| **0.5 - 0.7** | Moderate (typical equity portfolio) |
+| **> 0.7** | Poor (positions move together) |
+
+## Risk Scoring Framework
+
+### Composite Risk Score (0-100)
+
+Combine multiple metrics into single score:
+
+**Scoring Formula:**
+
+```
+Risk Score =
+  (Volatility Score × 30%) +
+  (Beta Score × 20%) +
+  (Drawdown Score × 25%) +
+  (Concentration Score × 25%)
+```
+
+**Individual Component Scores (0-100):**
+
+**1. Volatility Score:**
+- <10% std dev: 0-20 points (low risk)
+- 10-15% std dev: 20-40 points
+- 15-20% std dev: 40-60 points
+- 20-25% std dev: 60-80 points
+- >25% std dev: 80-100 points (very high risk)
+
+**2. Beta Score:**
+- β < 0.8: 0-20 points
+- β 0.8-1.0: 20-40 points
+- β 1.0-1.3: 40-60 points
+- β 1.3-1.6: 60-80 points
+- β > 1.6: 80-100 points
+
+**3. Drawdown Score:**
+- Max DD <10%: 0-20 points
+- Max DD 10-20%: 20-40 points
+- Max DD 20-30%: 40-60 points
+- Max DD 30-40%: 60-80 points
+- Max DD >40%: 80-100 points
+
+**4. Concentration Score:**
+- HHI <1000: 0-20 points
+- HHI 1000-1500: 20-40 points
+- HHI 1500-2000: 40-60 points
+- HHI 2000-2500: 60-80 points
+- HHI >2500: 80-100 points
+
+**Composite Risk Score Interpretation:**
+
+| Score | Risk Level | Appropriate For |
+|-------|-----------|-----------------|
+| **0-20** | Very Low | Ultra-conservative, retirees |
+| **20-40** | Low | Conservative investors |
+| **40-60** | Moderate | Balanced investors |
+| **60-80** | High | Growth-oriented investors |
+| **80-100** | Very High | Aggressive, long time horizon |
+
+## Practical Risk Assessment Workflow
+
+### Step 1: Calculate Basic Metrics
+
+1. **Portfolio Beta** (weighted average of position betas)
+2. **Standard Deviation** (if historical data available, else estimate)
+3. **Maximum Drawdown** (from portfolio history)
+4. **Current Drawdown** (vs recent peak)
+5. **Top-5 Concentration** (sum of 5 largest positions)
+6. **HHI** (concentration index)
+
+### Step 2: Compare to Benchmarks
+
+**Against S&P 500:**
+- Is beta higher or lower than 1.0?
+- Is volatility higher or lower than ~16%?
+
+**Against Risk Profile Targets:**
+- Does risk level match investor's stated risk tolerance?
+- Is maximum drawdown acceptable?
+
+### Step 3: Identify Risk Concentrations
+
+**Position-Level:**
+- Any position >15%? → Immediate trim
+- Top 5 >50%? → High concentration
+
+**Sector-Level:**
+- Any sector >35%? → Concentration risk
+- Any sector missing? → Diversification gap
+
+**Factor-Level:**
+- All high-beta growth stocks? → Factor concentration
+- All value stocks? → Style concentration
+
+### Step 4: Risk-Adjusted Performance
+
+1. **Calculate Sharpe Ratio** (if return history available)
+2. **Compare to benchmark:** Is portfolio delivering better risk-adjusted returns?
+3. **Calculate Sortino Ratio** for downside focus
+4. **Assess if excess risk is being rewarded**
+
+### Step 5: Generate Risk Assessment
+
+**Summary Format:**
+
+```markdown
+## Portfolio Risk Assessment
+
+**Overall Risk Profile:** [Conservative / Moderate / Growth / Aggressive]
+
+**Risk Score:** XX/100 ([Low / Medium / High / Very High])
+
+**Key Metrics:**
+- Portfolio Beta: X.XX (vs market 1.00)
+- Estimated Volatility: XX% annualized
+- Maximum Drawdown: -XX% (acceptable for [risk profile])
+- Current Drawdown: -X% (vs recent peak)
+
+**Risk Concentrations:**
+- Top 5 positions: XX% of portfolio ([OK / High / Excessive])
+- Largest single position: [SYMBOL] at XX% ([OK / Trim recommended])
+- HHI: XXXX ([Well-diversified / Concentrated])
+
+**Risk-Adjusted Performance:**
+- Sharpe Ratio: X.XX ([Below / In-line / Above] market)
+- Sortino Ratio: X.XX
+- Performance for risk taken: [Excellent / Good / Fair / Poor]
+
+**Risk Recommendations:**
+- [List specific actions to reduce risk if needed]
+```
+
+## Risk Management Guidelines
+
+### When to Reduce Risk
+
+**Signals:**
+- Portfolio beta >1.5 for moderate risk tolerance investor
+- Max drawdown exceeds investor's tolerance
+- Single position >15% of portfolio
+- Sector concentration >40%
+- Current drawdown >20% (entering bear market)
+
+**Actions:**
+- Trim concentrated positions
+- Add defensive sectors (Utilities, Staples, Healthcare)
+- Increase bond allocation
+- Raise cash levels
+
+### When to Increase Risk
+
+**Signals:**
+- Portfolio beta <0.7 for growth-oriented investor
+- Cash position >15% (unless intentionally defensive)
+- Underperforming benchmark significantly with lower volatility
+- Long time horizon with conservative allocation
+
+**Actions:**
+- Add growth sectors (Technology, Consumer Discretionary)
+- Increase equity allocation
+- Deploy excess cash
+- Add higher-conviction positions
+
+## Summary
+
+**Key Takeaways:**
+
+1. **Multiple metrics needed:** No single metric tells the full story
+2. **Volatility measures:** Standard deviation and beta for overall risk
+3. **Downside risk:** Maximum drawdown, current drawdown, VaR for worst-case scenarios
+4. **Risk-adjusted returns:** Sharpe and Sortino ratios for performance quality
+5. **Concentration:** HHI and top-N positions for diversification assessment
+6. **Match to investor:** Risk metrics must align with risk tolerance and goals
+7. **Monitor continuously:** Risk characteristics change as markets move
+
+**Practical Application:**
+
+- Calculate key metrics quarterly
+- Compare to investor risk tolerance
+- Identify concentrations and gaps
+- Adjust allocation to maintain target risk level
+- Document risk assessment in portfolio reports
+
+**Remember:** Risk metrics are tools, not absolute truth. Use judgment and consider qualitative factors (market environment, economic outlook, investor circumstances) alongside quantitative metrics.