What is in this article?:
- Q&A: Putting Risk First
- Part One: Using Risk to Your Advantage
- Part Two: Understanding Risk Budgeting
- Part Three: Dealing with Investment Loss and Volatility
Part One: Using Risk to Your Advantage
Why should investors focus on risk when determining asset allocations?
Marina Gross: Now that the markets are less predictable and more demanding, it’s important to look past the surface and figure out what risks you are really exposed to. Considering risk first leads to a set of binary decisions. On the one hand, you want to cap and control certain risks because the payoff is not attractive. On the other, there are risks you want to exploit because they have the greatest likelihood of a good payoff. Currently in the U.S., interest rate risk is being suppressed in many portfolios while illiquidity or emerging markets risks hold out greater potential for returns.
Franck Nicolas: We believe investors should always make risk their number one priority. This means targeting a consistent range of risk, rather than a potential range of returns. Many investors have started to do this but need to be much more precise about how they implement it.
Are the risks the same for all investors?
Marina Gross: I work with retail platform providers and advisors, and it’s clear that many retail investors struggle with the concept of risk. We help them to understand what forms risk can take, how they can measure it and the shortcomings of each of those measures. We often apply this to model portfolios and report back on issues such as risk concentration, and whether the composition of a portfolio is consistent with an investor’s expectations and intentions.
Franck Nicolas: For institutions such as pension funds, the asset-liability spread is a significant risk. If liabilities are believed to inflate over time, then you have a big inflation risk and your investment strategy should reflect that with an allocation to index-linked bonds and so on. If, on the other hand, your liabilities are in a number of different currencies, then the foreign exchange risk needs to be identified. Conversely, if your liabilities are purely domestic, you need to be very careful not to introduce too much currency risk into the portfolio. The strategy we advise is to design a bucket of risk with the best mix of asset classes that can close the gap between assets and liabilities in the long run.