What is risk budgeting and can it boost returns?

Franck Nicolas: Investors need to understand what can happen to their portfolios in both good times and bad times. In this way institutions will not be too surprised about the effects on their investments when markets fall and panic them into bad decisions. Obviously it is important to do this proactively, because having to react to a difficult landscape leaves you with fewer options.

Marina Gross: Risk budgeting essentially recognizes that investors have a finite tolerance for risk. When you quantify your risk tolerance, you can go into the marketplace and spend your risk budget to get the most yield or output per expenditure. Every decision becomes a trade-off: if you are conservative here, then you can be more aggressive there. If you spend more of your risk budget on small-caps because you believe you can capture higher returns, it needs to be balanced with something more conservative. You end up with two buckets: one return-seeking and the other risk-reducing, each weighted according to your risk budget, or your risk tolerance.

How can investors measure their risk tolerance to arrive at a risk budget?

Franck Nicolas: Institutions with defined liabilities need to establish their cash flow needs over time and then examine how these could be modified by changes in longevity, inflation, market movements and so on. Investment policies will reflect these factors and will need to be monitored dynamically to foresee potential deviations between assets and liabilities. It is not the kind of exercise that is carried out once; it’s ongoing.

Marina Gross: We counsel many of our clients to use a volatility range, as measured by standard deviation,* to define their risk tolerance. Standard deviation is readily available, standardized and understood by advisors. To ascertain the efficiency of each asset class we would typically use the Sharpe Ratio [a statistical measure which measures the return premium per unit of volatility]. When faced with a decision to take risk out of the portfolio when risk parameters have been violated, we would recommend, for instance, taking assets with declining Sharpe Ratios out of the return-seeking bucket.

Are there traps to avoid in setting risk budgets?

Franck Nicolas: Investors commonly make two mistakes in their risk budgeting processes. The first is to overlap two categories with similar risk profiles, such as overweighting emerging markets and commodities. The second mistake is to size all their risk buckets equally. Investors may be bullish on inflation, the U.S. dollar and Chinese equities, but the volatility of each is very different. Risk budgeting can help you to size each bucket more effectively.

*Standard deviation measures the risk of a portfolio or market. Standard deviation is a statistical measure of historical volatility.