Speaking of portfolio management and the challenges of generating real returns, especially in a high-inflation economic environment, yesterday, my attention was drawn to a technical comment on Bloomberg that argued the 60% equities/40% bonds portfolio theory had become valid again. The comment said that the correlation is now reversed after the chaos of 2022.
Speaking of portfolio management and the challenges of generating real returns, especially in a high-inflation economic environment, yesterday, my attention was drawn to a technical comment on Bloomberg that argued the 60% equities/40% bonds portfolio theory had become valid again. The comment said that the correlation is now reversed after the chaos of 2022.
In 2003, one of the financiers I most admire, Alejandro Reveiz, introduced me to risk budgeting and taught me its theory. My work since that year in investment portfolio risk management has had this theory as its common denominator. It is inexplicable that 20 years later, having gone through three major economic and financial crises, there are still those who invest without using the theory of Risk Budgeting and focusing exclusively on the 60/40 portfolio.
Incidentally, it is perhaps the best defence given the changes in the global economic order.
Below is a brief introduction to this theory.
Definition: Risk Budgeting is a portfolio management approach that allocates risk across investment strategies or asset classes within a predetermined risk budget. Its objective is to optimise risk-adjusted returns while managing the portfolio's total risk exposure.
The fundamental concept is that the total risk of a portfolio can be divided into risk contributions from its individual components, such as asset classes, investment strategies, or specific securities.
Each component is assigned a risk budget, which represents the maximum level of risk it can contribute to the overall portfolio.
By allocating risk budgets, portfolio managers can actively manage the risk exposures of different components and diversify risks across various assets or strategies.
This approach ensures that no single component dominates the portfolio's total risk, thereby reducing concentration risk.
The risk budgeting process typically involves the following steps: risk assessment, risk allocation, monitoring, and rebalancing.
Risk Assessment: This involves identifying and quantifying the risks associated with each portfolio component. This includes evaluating historical performance, volatility, correlations, and other risk metrics.
Risk Allocation: This involves determining risk budgets for each component based on its risk characteristics and the portfolio's desired risk/return objectives. This can be done using quantitative models, optimisation techniques, or expert judgement.
Risk Monitoring and Rebalancing: This requires regularly monitoring the risk exposures of the different components and rebalancing the portfolio if necessary. This involves adjusting allocations to ensure that risk budgets are not exceeded and to maintain the desired risk objective.
Improved Risk Management: Risk Budgeting helps investors take a proactive approach to risk management by setting limits and guidelines for risk exposure, thereby improving risk control and mitigation.
Improved Performance Evaluation: By evaluating investment performance against predefined risk objectives, risk budgeting provides a comprehensive assessment of returns relative to the level of riek assumed.
Strategic Asset Allocation: Risk budgeting facilitates asset allocation based on risk levels, allowing investors to optimise their portfolio's risk/return profile and align it with their objectives.
Greater Diversification: Risk budgeting promotes diversification by spreading risk across different asset classes or investment strategies, thereby reducing the impact of individual risks.
Implementation Challenges: Implementing risk budgeting strategies can be complex, requiring sophisticated models, data, and analysis. It can be challenging for individual investors or those who lack access to advanced risk management tools.
Over-Reliance on Historical Data: Risk budgeting often relies on historical risk measures, which may not fully capture the complexities and uncertainties of future market conditions.
Potential for Underperformance: The strict constraints of risk budgeting can limit flexibility to capitalize on short-term opportunities or adapt to changing market dynamics, potentially leading to underperformance in certain scenarios.
Inaccurate Risk Assessments: Risk budgeting relies on statistical risk models and assumptions, which may have limitations and inaccuracies, potentially affecting the accuracy of risk assessments and allocations.
In conclusion, risk budgeting offers several benefits, including improved risk management, enhanced performance evaluation, strategic asset allocation, and greater diversification. It provides a structured approach for investors to control and mitigate risk while optimising the risk/return efficiency of their portfolio.
However, risk budgeting also presents challenges related to complexity, potential over-reliance on historical data, the risk of underperformance, and the accuracy of risk assessments. It requires careful consideration and detailed implementation to ensure its effectiveness in aligning risk exposure with objectives and adapting to changing market conditions.
Source: LinkedIn post by Gustavo Madrid-Malo (May 2023)
