#Investments — 24.02.2017

Did you say risk budget?

Luc Lefer

We all know what a budget for everyday living is; but what is a risk budget in the context of wealth management?

The notion of budget takes into account the dimension of anticipation (covering future expenses, whether recurring or a specific project to be financed) and limitation (define a minimum and/or maximum amount). This notion may also be used in financial management for setting the level of risk we are prepared to accept.


What risk?

In the area of wealth management, the risk budget is the limit set for the fluctuations in assets of a different nature (e.g. equities, bonds, gold). Indeed, each type of financial asset is associated with a level of risk which may be expressed in various indicators* which all measure the fluctuations of an asset.

The most commonly used indicator is volatility which is defined quite simply as the extent of price fluctuations in a financial asset compared with its average over a given period. The greater the extent of the asset’s fluctuations, the riskier it is considered to be. And, the riskier the asset, the higher the expectation of a gain (or a loss).

For example, shares are more volatile than government bonds. Indeed, a share is more likely than a government bond to fall in value because the latter’s redemption is practically certain. In concrete terms, when we say that the volatility of a share is 12%, this means that compared with its historical average (over a given period), it may fluctuate to the upside (or to the downside) by up to 12%. Assets have different levels of risk. If we take the previous example, shares have an average volatility of around 16% compared with 1.5% for government bonds. Furthermore, they do not all move in the same way. When two assets move in the same direction (upwards or downwards) they are said to be positively correlated and if they move in opposite directions, they are negatively correlated.


What is the definition of a risk budget?

The budget consists of setting a maximum level of risk when creating a portfolio of several assets:

  1. Firstly, it is a way of pre-defining the range of fluctuations in the portfolio by carrying out an initial assessment based on an historical analysis (ex-post volatility) or an analysis of market expectations (ex-ante volatility or implied volatility).
  2. This framework shapes the process of selecting assets with a view to monitoring regularly that the budget is respected.
  3. Moreover, it facilitates the task of reducing the portfolio’s overall risk by selecting assets that have different levels of risk or are negatively correlated.

Risk budgeting is the job of a discretionary portfolio manager who is responsible for managing this diversification of assets with a dual objective: the search for yield and the respect of the budget risk.

By way of illustration, the portfolio manager gathers all the pieces (assets) of a jigsaw, making sure that they are compatible (risk levels and correlation) to achieve the best possible risk-return ratio. However, although portfolio management requires the same patience as doing a jigsaw, it is a never-ending story. Indeed the levels of risk and correlation are not stable over time. Events continuously influence the level of risks (e.g. events in the markets or in the life of a listed company, etc.). The risks increase in periods of instability or low visibility and vice versa. In other words, the shapes of the jigsaw pieces move all the time.


Is a budget really necessary?

It is not only necessary, it is indispensable!

Firstly the notion of risk is necessarily associated with the notion of return or performance. Moreover, by way of comparison, could we imagine driving with no speedometers? No because they are indispensable! Finally, there are growing regulations in terms of risk monitoring and their communication to holders of financial products.

A great sportsman once said "To win, you have to risk losing".

The risk budget helps to clarify how far you are prepared to go to lose….to win.

*such as volatility, VaR (Value at Risk) and maximum drawdown