Enterprise Risk Management: From Incentives to Controls, 2nd Edition

CHAPTER 7

Portfolio Management

It took seven years to persuade super-investor Warren Buffett to be the subject of Nightline, the ABC network's flagship news program. At that time, Buffett's Berkshire Hathaway investment vehicle had posted a succession of returns that put its competitors to shame; Buffett himself was known as “the sage of Omaha” and regarded by many as the world's shrewdest investor. To kick off the interview, the host, Ted Koppel, asked Buffett what he did for a living. Buffet reflected for a second and replied: “I allocate capital.”

That short answer from one of the greatest investors of our times encapsulates an important lesson for all business managers. Capital allocation is a critical concept for all businesses: not just money managers, but also for other financial institutions, energy firms, and non-financial corporations. Capital is the link between risk and return; hence, a sound capital-allocation process is critical to business development and the creation of shareholder value.

Capital is typically allocated by evaluating a set of investment opportunities, then selecting those that meet a set of predetermined investment objectives. Over time, the investments aggregate into portfolios—a research and development portfolio, a securities portfolio, an asset/liability portfolio, and so on. In essence, a company should be viewed as a portfolio of businesses, each with its own unique risk/return characteristics.

In most enterprises, the various business portfolios ...