Imagine trying to safely pilot an airplane to its destination, but you only know how much fuel you have and the distance from here to there. Even the most experienced pilot would have trouble making the right decisions.
Now imagine you have access to the full flight-management system. You can see engine thrust, wind vectors, altitude bands and early warning alerts. Every decision becomes clearer, even if the route ahead isn’t.
Unfortunately, many investment portfolios are constructed with a fuel-gauge mentality. An investor might know how much risk they are taking, but they lack the tools to assess where that risk is coming from or the ability to understand if the risks are intentional and scaled appropriately.
The investment industry’s focus on volatility and capital allocation as primary risk measures neglects a lot of useful information. Let’s break it down.
In 1952, Harry Markowitz introduced modern portfolio theory (MPT) with his essay “Portfolio Selection” in the Journal of Finance. He explained how investors can construct portfolios to maximize expected returns based on a given level of risk.
The concept is known as mean-variance optimization (MVO). It showed investors how to construct portfolios and laid the foundation for the field of quantitative finance.
More than 70 years later, MVO is still one of the most-used quant tools in asset management, and volatility has become the widely accepted industry standard for measuring the level of risk in a portfolio.
The trouble with volatility
Volatility alone is a poor measure of risk because it’s simple and backward-looking. It penalizes the upside as much as the downside.
It rewards exposure to illiquid assets. It’s not directional. It doesn’t account for changing economic conditions or market regimes. It also ignores left tail risk, fat tails and the tendency for investments to either trend or mean revert.
The benefit of MPT was that it provided a framework for allocating risk in a portfolio rather than simply allocating capital. Over the past 73 years, allocators have built on this foundation to create more comprehensive approaches to risk budgeting in portfolio construction.
For example, risk-factor models are now used to provide a total portfolio view of risk that looks through each asset and strategy to enable risk to be thoughtfully allocated in multi-asset, multi-strategy portfolios.
This approach allows for portfolios constructed with building blocks that aren’t just diversified by label, but that are truly diversified by risk exposure. This avoids the hidden correlations and unintended exposures that can cause portfolios to disappoint at the worst times.
Returning to the pilot metaphor, risk budgeting and the tools associated with this framework are like having access to the full flight-management system that allows you to make more informed decisions.
Make better use of your portfolio’s risk budget
Three recommendations:
- Start with the beta footprint. Use a risk-factor model to understand your portfolio’s beta footprint, or how much exposure your portfolio has to the overall market. This allows you to understand the key drivers of risk and return in your portfolio so you can make sure risk exposures are intentional and scaled appropriately.
- Allocate risk, not dollars. Dollars tell you where money sits, but risk reveals what really drives outcomes. With your risk model in place, you can begin allocating your risk budget more efficiently. You’ll be able to allocate capital to assets and strategies that provide genuine diversification, deploying each unit of risk where it can work hardest, and giving no single risk undue influence over your investment outcome.
- Apply a goal-based framework. Consider not just portfolio risk, but also shortfall risk. That is the risk that an investment portfolio will be unsuccessful in funding investor goals. For many investors this will mean reducing dependence on interest rates and equity markets so that their portfolio has the potential to perform well across a broad range of potential economic and market scenarios.
Creating more resilient portfolios starts with thinking differently about how we build portfolios from the ground up.
For existing portfolios, it means reallocating assets and strategies to better account for the many risks we can see, and the ones we can’t. Taking a total portfolio approach and designing portfolios using a risk-budgeting framework is one of the many ways advisors can bring greater certainty to investors.
Robert Wilson is SVP, head of innovation, portfolio strategist with Picton Mahoney Asset Management.