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Portfolio risk contribution of an investment tends to differ from its portfolio weight. In some cases intuition may be misleading – a good example is the traditional 60/40 portfolio. It is paramount to assess the impact from each position in a portfolio. It is no secret that portfolio risk contribution of an individual security almost always differs substantially from its portfolio weight. However, investors frequently overlook this simple truth and tend to focus on notional dollar amounts invested. I have compiled a few examples that clearly illustrate why risk contributions matter. Let’s start with the traditional 60/40 portfolio, where SPDR S&P 500 ETF (NYSEARCA: SPY ) is used as a proxy for equities and iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) for bonds. Analyzing this portfolio on InvestSpy Calculator with 1 year historical data, we get the following results: The table above tells us that even though TLT had a slightly higher annualized volatility than SPY (which is an interesting fact in itself), its risk contribution to the total portfolio volatility was only 21.4% – way below TLT’s portfolio weight of 40%. And the difference would only get wider if we used shorter duration bonds for the fixed income component. So even though an investor may intuitively feel well diversified between stocks and bonds, almost 80% of portfolio risk comes from the equities component. Big discrepancies between portfolio weights and actual risk contributions can arise in equities-only portfolio as well. I came across the next example while writing a recent article about the ‘Fab Five’ stocks. Assuming a simple hypothetical portfolio where 50% is invested in SPY ETF and 50% in Google (NASDAQ: GOOG )(NASDAQ: GOOGL ), risk contributions from each position are far from even: This gap between risk contributions is primarily factored by the fact that GOOG is by far a more volatile security than SPY. The third example I would like to present is a portfolio that includes emerging market stocks. Investors are frequently reminded of a home country bias in their allocations and encouraged to include international stocks in their portfolio. So if a US investor allocates 20% to Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) with the remainder sitting in SPY, the risk profile of such a portfolio looks as follows: The risk contribution of the VWO position appears to be fairly close to its portfolio weight. Interestingly, the annualized volatility of the portfolio is only a tad higher than that of SPY’s in isolation despite the fact that VWO is significantly more volatile security. This is a direct result of the diversification effect. Therefore, the addition of emerging market stocks to diversify a portfolio of US stocks looks like a sensible decision. I hope the examples above give the readers a bit of a flavor how risk contributions work and why they are important. It is crucial to look beyond notional amounts invested in each position to assess if your portfolio is balanced the way it was intended. You will be surprised in some cases. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.