This article initially appeared on Morningstar's Canada website, written by Michael Ryval, a Toronto-based contributor to Morningstar.ca.
The manner in which money is distributed across asset classes in your portfolio is often called capital budgeting and focuses mainly on returns. Yet according to Perry Teperson, vice-president at Vancouver-based Leith Wheeler Investment Counsel Ltd., you should consider another perspective known as risk budgeting.
"You want to understand where the risk is coming from in your portfolio and understand what impact it might have, typically during a stressed or difficult time when risk is more of a concern than return," says Teperson, who joined Leith Wheeler in 2004 after 13 years as an actuary and investment consultant. "The total risk of a capital loss is usually the most pressing risk for a retail investor, so you want to know where that risk is coming from. Are the asset classes contributing equally, or is one contributing more than the other? You want to ask, 'How can that impact my portfolio if there is a difficult period?'"
Teperson argues that, generally speaking, investors are more focused on the return question. "They tend to think, 'How do I build a portfolio so that I get a particular rate of return?' But people have taken their eyes off the risk question because we've had enough time since the 2008 financial crisis," says Teperson, a South African native who earned a bachelor of business science at the University of Cape Town. "Investors are naturally gravitating more to equities. They're thinking, 'How much more do I put into equities or other riskier asset classes so that I can meet my targeted return?'"
But investors must keep an eye on risk, too, as part of their decision. In a hypothetical conversation with clients about asset allocation, Teperson says, "We would ask, 'Are these bonds still a useful component in your portfolio? We would say they are, for diversification purposes.' So speaking of risk budgeting is the quickest way to get to that conversation."
Consider, for instance, a 60/40 mix of equities and bonds that suddenly declines by 10%. Invariably, most of that decline comes from the stock portion. "Slightly more than 90% of the risk comes from the equity side," says Teperson, citing research, while the fixed income side will reduce the size of the hit. "Even if bonds make up 40% of the portfolio, they are not contributing too much of the risk during a stressful period."
Indeed, Teperson says this may be confirmed if you look at your portfolio returns during the 2008-2009 crisis. "You probably had some negative returns from high-yield and corporate bonds. But they were more negative on the equity side. That's the quickest way to understand where the risk came from," says Teperson, who works closely with institutional clients. "You want to look at the different parts of the portfolio otherwise you won't have a feel for where the risk came from."
Determining the degree of risk in your portfolio is no easy task. If your equity position is held in broad-market exchange-traded funds, you can gauge the risk because market risk, known as beta risk, can be measured. Yet it is much harder to quantify risk tied to active management, or alpha, because it differs considerably from passive investments that track broad markets.
"Most institutional investors and pension fund managers would not drill down deeper. They would pick the best managers they can find. Sometimes they will choose managers who offer some of the risk management they are looking for. A value manager, for instance, may do better in a down market. That's one way to factor in these kinds of decisions, rather than do a bunch of mathematical calculations about active manager risk."
Teperson concedes that investors may not be interested in risk budgeting when markets are humming along and their portfolios are showing solid returns. Yet they should not become complacent and conclude there is little to worry about. In fact, Teperson says, this is precisely the time to question if you are exposed more than your comfort level, or risk tolerance, in a down market.
"People should spend some time with their advisors and understand what happens when the tide runs out," says Teperson. "And they might ask, what would it mean if they had a slightly less risky portfolio during a stressful time? For instance, if they moved from a 60/40 asset mix to a 50/50 mix, they should ask, 'What would it mean both for returns and risk management during stressful times?' This should help them understand what the risk drivers are."
