Putting Risk on a Budget

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Investment risk is one of those things that’s not very easy to describe—no less budget for. This may well be keeping investors from making the most productive use of their assets.

Indeed, findings from BlackRock’s Global Investor Pulse survey reveal that one-third of advised U.S. respondents feel certain they would invest more if they had a better understanding of the risk levels in their portfolios. Another third would possibly invest more with a better understanding of these risks.

Our work with financial advisors reveals that defining and keeping risk on a budget isn’t easy. We generally see two different approaches to portfolio construction aimed at improving the experience of the markets: 1) Achieve a return similar to your benchmark but with less total risk, or 2) generate a higher return than the benchmark, but at the same risk level. Of the first set, only 35% of the portfolios we surveyed met the stated risk goal; in the second set, 53% met their risk target.

Risk Budgeting

Investors are not intentionally building portfolios that miss their risk benchmarks. Many of the products used in building portfolios today have simply become more volatile than the market itself.

Consider that, 10 and 20 years ago, less than half of broad equity funds were riskier than the S&P 500 Index of large-cap U.S. stocks, according to data from Morningstar. Today, the number is 75%—markedly higher than the historical precedent.

Rationalizing risk

What’s an investor to do in this environment? We recommend keeping a few things in mind as you seek to understand and budget risk:

Keep it real

The framing of risk can make all the difference. Consider that a $100,000 investment in an asset with an annualized level of volatility of 10% could easily undergo a drawdown of $10,000 in any given year. The question isn’t whether 10% volatility feels OK to you. It’s: “Can I bear a loss of $10,000 in value at any moment in time?” If the answer is no, you likely need to consider more conservative options or balancing that asset with a less volatile investment.

Diversify risks, not just asset classes

Just because we call a security a stock or a bond doesn’t mean it will always act like one. Case in point: High-yielding stocks can sometimes serve as bond proxies, and lose value when rates rise. It’s important to look beyond the labels to understand the risk drivers behind each asset you’re choosing. The goal, for example, is to understand the amount of equity risk you have—not simply the amount of equities you own. Only then can you truly diversify your portfolio.

Don’t assume recent history will repeat

Measuring the risk associated with past returns will not always paint a complete and accurate picture. The S&P 500 Index has demonstrated annual volatility below 11% in four of the past five years. The historical norm observed over the prior four decades was 15%. So which is right? There are no crystal balls in investing, but working with an experienced advisor and an investment manager with expertise in the strategy you’re pursuing can bestow valuable perspective.

Know the risks you’re taking

And the more risks you understand, the better. BlackRock has identified over 2,200 unique risk factors, and has a powerful system to measure any given portfolio’s sensitivities to different types of stress scenarios. Our risk-management technology analyzes the ongoing relationships between millions of tradable securities around the globe, giving our investors access to a vast amount of risk intelligence.

Contemplating risk on these dimensions can help ensure the risks you’re taking are deliberate, diversified and appropriately scaled. And putting your portfolio on a risk budget can not only help you stay away from danger zones along the journey toward your long-term investing goals, but can also help you to better navigate the emotions that go along with investing—no matter how you define “risk.”

Patrick Nolan is the Portfolio Strategist within BlackRock’s Portfolio Solutions group. He is a regular contributor to The Blog.


Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of July 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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