The New Science of Asset Allocation: Risk Management in a Multi-Asset World

CHAPTER 9

Risk Budgeting and Asset Allocation

Asset allocation and risk management are about finding the right balance of risk and return. In this chapter, we focus on several practical techniques that can be used to measure, monitor, and manage the risk of a portfolio. What we want readers to take from this chapter is that asset allocation is the same as risk allocation and that the road to a portfolio which meets an investor’s investment goals through time comes from actively monitoring and managing the risk of the portfolio.

The concept of risk-adjusted returns is not easy to explain because there is no consensus on how the “true” risk of a portfolio should be measured and because, as was discussed in previous chapters, risk cannot be measured in isolation—it depends on other assets and liabilities of the investor. While an investor’s interest is on the total return generated by a portfolio, good returns are difficult to achieve. The fact that markets are efficient most of the time means that high returns will typically come at the cost of higher risk. The good news is that while managing a portfolio to earn a high rate of return is difficult, managing the risk profile of a portfolio is relatively easy.

PROCESS OF RISK MANAGEMENT: MULTI-FACTOR APPROACH

Risk management is a process that involves several steps. When it comes to risk management of multi-asset portfolios, the first step is to understand the investor. What are her attitudes toward risk, what are her liabilities, ...