In determining a risk budget, choose wisely.
Investing is about taking calculated risks with the expectation that over time the risks will pay off. The process of deciding which risks to take on and how much to take of each is called risk budgeting. Whether investors do so consciously or not, whenever they form a portfolio they are setting a risk budget.
At Morningstar, we generally recommend a two-step process to forming a portfolio—first deciding how to divide the portfolio among various asset classes (the asset-allocation step) and then selecting funds or other investment products to gain exposure to the asset classes at the desired levels. I will recast this process in terms of risk budgeting to help show the risks in a portfolio and how they may or may not be rewarded, and how mistakes might be avoided.
Asset Allocation—Systematic Risk
First, let’s quickly review some basic principles about asset allocation. Investors take on investment risks if they believe that by doing so they will eventually reap the reward of returns above those available through risk-free assets such as money market funds or bank deposits. Otherwise, they would just keep their money in risk-free securities.
Risky investments have indeed paid off historically. This is certainly true at the asset-class level, where over long periods, indexes that measure risky asset classes, such as stocks, have outperformed less risky asset classes, such as bonds.
The difference between the long-run return that an investor expects to receive on an asset class and risk-free securities is the risk premium. Exposure to the asset class is sometimes called a beta exposure. Beta exposures are the foundations of an investor’s risk budget.
Through asset allocation, investors are deciding how much of each beta exposure to have. They do so to earn the risk premiums of the asset classes, intentionally exposing themselves to the risk of their overall asset allocation. This risk is called systematic risk because it is due to exposure to marketwide factors that cause the risky asset classes to be risky.
These days, investors go beyond broad asset classes and make allocations to groups of securities that have particular characteristics. For example, research shows that portfolios of stocks of smaller companies tend to outperform portfolios of larger companies over long periods. Similarly, portfolios of stocks that have more favorable valuation ratios tend to outperform portfolios of stocks with less favorable ratios. These two phenomena, known as the size effect and the value effect, are premiums that investors can gain access to by tilting the stock part of their portfolios toward these stocks. These portfolio tilts are beta exposures and, thus, belong to the systematic risk part of the portfolio’s risk budget.
The most widely used analytical framework for asset allocation is the mean-variance framework, which was first introduced by Harry Markowitz in 19521 and for which he shared the 1990 Nobel Prize in Economics. Markowitz’s key insights are: