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We are all familiar with the traditional idea of basic budgeting: you set up a plan for how much money you will save and spend each month. “Risk budgeting” is much the same idea for investors, but involves setting up a plan for how much risk you plan on taking with your long-term investments.

Risk surveys and investor questionnaires go part of the way. They ask questions and assess an investor’s self-reported tolerance for risk and then match the investor to a certain asset allocation. This is fine as long as that asset allocation maintains a constant risk level over time. The problem here is that the risk levels associated with almost every asset class vary over extended periods of time, resulting in a specific asset allocation’s risk level changing over the years. Risk levels of a specific asset allocation can change materially through time as a result of changes in the relationships between asset classes (correlations), changes in market risk levels and changes in sector-specific risks.

For this reason, investors need to keep risk within a given range (a.k.a. the “risk budget”) rather than assuming that a static asset allocation will provide this for you. I want to write about risk budgeting today, because I think it will become a very important tool for investors in the future.

What is Risk Budgeting?

Risk budgeting is a standard practice among institutional investors:

“It’s a truth universally acknowledged that a fund manager seeking to take effective control of investment risk across asset classes must be using or looking to use risk budgeting.”

--Laurence Wormald, Head of Research, Sungard (January 2011)

If you Google the term, you will find numerous articles and books aimed at institutional investors. Fortunately for individual investors and their advisors, you do not need to comprehend anything as complex as is expressed in most of these treatments.

For the purposes of the individual investor, what is critical to understand is that the risk level associated with any given portfolio changes over time and that these changes need to be tracked and managed.

Fighting Long-Term Memory Loss

Unfortunately, the majority of retail investors tend to do the reverse of risk budgeting. When risk levels remain low for a period of time, investors as a whole, tend to become more and more aggressive in their investing strategies—and this is one of the reasons that investment bubbles grow.

For example, if you had bet on tech stocks in the late 1990s and received substantial gains for six months, you were likely to have bet even more heavily on tech stocks in the next six months. (In fact, one could say that the same thing occurred with the housing market over the past few years). The longer it’s been since something bad happened, the more people tend to discount the risk they are taking (this is known in Behavioral Finance as a “recency bias”). Risk budgeting counteracts recency bias by setting up objective estimates for total portfolio risk and keeping the portfolio within the acceptable risk bounds. In this way, risk budgeting acts like a more rational form of portfolio rebalancing (as I explained in an article in 2007):

“Is there any theoretical reason, based on financial theory, why specific allocations to specific sectors are preferable to letting the allocations weights drift? No. There is, however, a case to be made that it is a reasonable idea to re-balance your portfolio when its risk-return profile has drifted substantially from target levels. If your portfolio volatility gets substantially higher over time, you may consider selling some high risk assets and buying some lower risk assets to replace these. On the other hand, if your portfolio volatility declines substantially, you may want to re-balance to bring the risk/return balance up to your desired levels.”

From a risk budgeting perspective, a strict schedule of rebalancing is not necessary. A portfolio needs to be rebalanced only when its total risk level has moved outside of an acceptable range from the desired target risk level. Knowing when your portfolio’s risk has drifted too far from target levels requires quantitative tools, of course.

The Three Steps of Risk Budgeting

There are three steps involved in risk budgeting. First, you need to come up with a target risk level for your portfolio. Second, calculate an estimate of total portfolio risk and build a portfolio that matches your target risk. Third, manage the portfolio to maintain the risk level close to the target level. Target date funds are a popular one-step solution that addresses all of these steps. In fact, by designing our alternative solution, Target Date Folios, we did the work for you by:

1) Creating target risk levels for each point in an investor’s life

2) Designing asset allocations to meet each risk level

3) Periodically revisiting the risk levels associated with the asset allocations and adjusting the allocations if the projected risk no longer matches the target risk.

It is possible to come up with expected risk forecasts for individual asset classes and for portfolios as a whole. I’m not going to go into detail here, but a recent post here at the Portfoloist provides an introduction to the process of estimating risk for individual asset classes. The next step is to calculate total portfolio risk using these estimates, along with information on the correlations between asset classes. The lower the correlations, the lower the risk will tend to be.

Final Thoughts on Risk Budgeting

Risk budgeting has number of interesting outcomes in terms of the way the portfolio management changes.

We went through a period of very low volatility in the years leading up to 2007, which led many investors to increase their portfolio risk levels because higher-risk asset classes simply did not ‘feel’ risky. Investors who used risk budgeting during this period would have had a very different expectation of future risk levels. The Target Date Folios were designed in mid 2007 and my largest concern at that time was that the reasonable expectation of the three risk levels we designed (conservative, moderate and aggressive) was much higher than the levels experienced over recent years.

Risk budgeting had a substantial impact on the asset allocations in the Target Date Folios at the end of 2010. In particular, the correlations between almost every asset class were much higher than their historical levels. As a result, many of the original asset allocations looked riskier, and we adjusted the asset allocations. We didn’t change the target risk levels—we simply changed the asset allocations for the expected risk levels so that our original targets were consistent.

Risk budgeting is not something that the average investor can easily do for themselves. If doing so does not appeal to you consider that one of the real benefits of Target Date strategies (and Target Date Folios) is that they already provide risk budgeting for the average investor.

Source: Risk Budgeting: A Critical Tool For Portfolio Management