Ioulia Tretiakova_

Risk-Based Asset Allocation: Worth the Effort

Indexor,

As you say, most individual investors do not care about standard deviation or volatility. I wouldn’t say the same for institutional investors, however. But most investors certainly do care about risk: they hate loosing money. Professional money managers, from a business continuity standpoint and because of their responsibility to manage clients’ money in a manner that would allow them both to sleep well at night, must try to control portfolio downside. Risk-based asset allocation does just that.

The risk budgeting approach does not necessarily produce lower risk portfolios: in quiet markets one would in fact increase the aggressive holdings weight, which would actually produce a portfolio that does better than its static asset mix counterpart.

As we know, positive and negative returns are asymmetrical in dollar terms and to recoup a 25% loss we need 30% gain, a phenomenon also known as volatility drag. Clients do not need to understand all the terminology, but their portfolio manager must. A risk-efficient downside-managed portfolio will generate better returns in the long term.