Risk Budgeting

Budgeting can be quite the task for some families as every dollar is stretched. For others, it's a fluid process because there's enough to go around. Same idea with risk. When it comes to managing risk, what type of investor would have the ability to easily allocate risk?

No. Risk-averse investors would be on a tight risk allocation.

Not quite. Risk-tolerant investors have the ability to take risk, but only to the extent of accomplishing their goals.

That's it! It's a risk-aggressive investor who has the ability to easily allocate risk between asset classes. That's the premise of risk budgeting, which answers the questions of which types of risks to take and how much to take. Essentially, it takes a different view of asset allocation, through a risk perspective. This allows you to choose your own risk perspective.

For example, you may use VAR, a variance, or standard deviation of returns to state a risk budget in absolute or relative terms and in money or percentage terms. When you think about it, a risk budgeting asset allocation approach is where an investor specifies how risk is measured and allocated across the portfolio. Notice that the sole focus is on risk allocation. What's the typical focus that's missing?

You got it! The expected returns aren't a focus of the risk budgeting process. It's all about the risk, not the return. That seems kind of counterintuitive, but it works when you consider using overall portfolio risk as an objective. It also works in the sense of __active risk budgeting__, which is the risk an investor is willing to take and allocate to beat a benchmark.

Not so. Anticipated volatility is a risk measure, so it's included in the risk budgeting focus.

Not quite. That's still a risk focus, so it's not missing from the risk budgeting approach.

This active risk budgeting approach can be applied to the strategic asset allocation benchmark at the overall asset allocation level (tactical asset allocation) or at the individual asset class level, where it impacts how specific asset classes are invested.

To sum it up: [[summary]]

Risk averse

Risk tolerant

Risk aggressive

Expected returns

Anticipated volatility

Deviation in risk versus a benchmark

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