Risk Control Process

Risk Defined
The Principle of Risk Mitigation
Asset Allocation Across Asset Classes
Asset Allocation Within Asset Classes
Asset Selection Rules

Risk Defined:

Risk is present when the outcome of some event is not certain. This can be visualized with the well-known bell-curve. The mid point represents the expected return (E[R]), and the dispersion represents the potential range of outcomes.

With regard to financial assets, there are two common ways of viewing this uncertainty:

  • The expected or historical degree of variability in returns, usually measured with a statistical concept called standard deviation. The greater the standard deviation, the wider the dispersion of returns as illustrated by the bell-curve.
  • The probability that returns will be less than some minimum objective. For example, we might be interested in the probability that returns will be negative and the investor will experience a loss.

The Principle of Risk Mitigation:
When we combine assets into portfolios, the portfolio risk is determined by the combination of the risk of the individual assets, and how the returns on these assets tend to move with each other.

The degree to which the returns tend to move together is measured by a statistical concept called correlation. The correlation must be between +1.0 and -1.0. Assets that have returns that tend to go up and down together will have positive correlations, and assets that have returns patterns that diverge will have negative correlations.

In theory, two assets that are extremely risky on a stand-alone basis, but that have a correlation of returns of -1.0, can be combined into a portfolio that will have no risk. The returns will always exactly offset each other leaving a net return of zero.

In practice, most assets are positively correlated, but the degree of the correlation between pairs of assets varies significantly. Thus, by constructing portfolios containing a variety of assets, we can effectively manage the level of risk present to meet investor preferences and requirements.

Asset Allocation Across Asset Classes:
Assets held by investors are often classified broadly into categories commonly referred to as asset classes. These asset classes include:

  • Cash
  • Stocks
  • Bonds
  • Real Estate
  • Precious Metals
  • Other Assets

Academic studies have shown that the vast majority of a portfolio’s risk and returns are determined by how the investments are allocated across these asset classes.

Asset Allocation Within Asset Classes:
But the asset allocation decision goes even further than the broad classes shown above. Within most classes there are sub-categories to which we must give consideration in the portfolio construction process. For example:

  • Stocks
    • Domestic vs. Foreign
    • Large Capitalization vs. Small Capitalization
  • Bonds:
    • Taxable vs. Tax-Exempt
    • Investment Grade vs. High Yield
  • Real Estate:
    • Office
    • Warehouse
    • Retail
    • Residential

Asset Selection Rules:
Finally, we need to complete the portfolio construction and risk mitigation process by following guidelines for the selection of specific assets. This includes consideration of factors such as:

  • Exposure by industry sector.
  • Exposure by individual asset.
  • Valuation.

Adherence to a disciplined risk control process can increase the probability that the portfolio will achieve the client’s objectives.

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