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 and how much to take of each is called risk budgeting. Whether you do so consciously or not, whenever you form a portfolio you 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.
In this article I recast this process in terms of risk budgeting to help you understand the risks in your portfolio and how they may or may not be rewarded, and to help you avoid mistakes.
Only take on risks that you believe will be rewarded
You take on investment risks if you believe that by doing so you will eventually reap the reward of returns above those available through risk-free assets such as money market funds or bank deposits. Otherwise you would just keep your 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 you expect to receive on an asset class and risk-free securities is known as the risk premium. Your exposure to the asset class is sometimes called a beta exposure. Beta exposures are the foundations of your risk budget. Through asset allocation, you decide how much of each beta exposure to have. You do so to earn the risk premiums of the asset classes, intentionally exposing yourself to the risk of your overall asset allocation. This risk is called systematic risk because it is due to exposure to the market-wide factors that cause the various risky asset classes to be risky. These factors include overall equity market risk, interest rate risk, real estate market risk, commodity market risk, etc.
These days, many investors go beyond broad asset classes and make specific allocations to groups of securities that have particular characteristics. For example, a large body of 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 favourable valuation ratios (such as price-to-earnings) tend to outperform portfolios of stocks with less favourable ratios. These two phenomena, known as the size effect and the value effect respectively, are additional premiums that you can access by tilting the stock part of your portfolio toward these stocks. These portfolio tilts are beta exposures and thus are part of the systematic risk part of your risk budget.
Should you choose to make 100% of your risk budget systematic risk, you can implement your asset allocation entirely with index funds or ETFs. However, if you have identified funds with managers that you believe can reliably outperform their benchmark indexes after fees, you can use them instead of index funds. The long-term average additional performance that you expect of an actively managed fund is called the fund's alpha. Alpha comes at a cost in the form of adding to your portfolio's risk above that of a portfolio of index funds. This additional risk is known as unsystematic risk because it is not related to systematic risk factors. Rather, it is due to the decisions of the fund managers.
If fund managers have no skill, unsystematic risk has no reward and should not be taken. Only if you are convinced that the managers you are considering have the ability to outperform their benchmark indexes after fees should you invest in their funds. In other words, only include unsystematic risk in your risk budget if you believe that you have identified managers that are likely to generate positive alpha.
Avoid unintended risks
The purpose of having a risk budget is to know what risks you are taking and why. However, this can get tricky when you use actively managed funds, especially those that invest in asset classes that make up only a small part of your portfolio, such as emerging markets stocks. The problem is that every actively managed fund is a combination of beta exposures and alpha-generating strategies, so that each fund contributes to both the systematic and unsystematic components of your overall risk picture. This can make it hard to keep your overall risk exposures where you want them.
For example, suppose that you decide to allocate a small portion of your portfolio to emerging markets equity and there is an actively managed emerging market fund that you believe generates considerable alpha. If you make too large an allocation to this fund, you end up with more exposure to the systematic risks of emerging markets equity than you originally intended.
There is nothing necessarily wrong with increasing your exposure to a given asset class, so long as it a conscious choice and you are prepared to suffer the consequences should these assets do poorly. In other words, changing your beta exposures in the pursuit of alpha is a reasonable thing to do so long as it is part of the risk budgeting process and not an unintended change in your risk exposures.
Do not diversify for diversification's sake
A common misconception of modern portfolio theory is that the more risk you take on, the higher the expected return. But this is not generally true. If you invest in an actively managed fund that does not generate positive alpha, you are taking on unsystematic risk with no corresponding reward. But it is also possible to take on more systematic risk than you need to get the level of expected return that you are getting with your asset allocation. It all depends on how well constructed your portfolio is. If you have a portfolio that has the highest possible expected return for its level of risk, then yes you need to up the risk level to get more expected return. But you may not be at that bliss point and may be able to both reduce risk and increase expected return.
Therefore you should be suspect of strategies that claim to maximize diversification, minimize risk, or achieve risk parity across asset classes but do not make reference to expected returns. Risk budgeting is not just about allocating risks. It is about doing so to obtain long-term expected rewards.
