The return of volatility has brought opportunity. The steady, upward trajectory of most markets in recent years provided few opportunities to tactically increase allocations to an oversold asset class. That backdrop finally may be changing.
The recent selloff has advisors and clients discussing how to nimbly take advantage if another correction looms. Before eyeing that entry point into a riskier asset class, however, advisors face a conundrum: How can they add a riskier — albeit attractively valued — asset class without upsetting the portfolio’s long-term risk profile?
It comes down to risk budgeting. The topic typically is the purview of dense whitepapers, but a back-of-the-envelope calculation shows how risk budgeting works and illustrates the challenge in front of advisors. It also shows the understated role alternatives can play in bringing portfolio risk back in balance.
Math Behind Tradeoff
To illustrate risk budgeting and the interplay between the assets an investor holds and wants to add, consider a client’s equity allocation. If the equity sleeve is purely U.S. large-cap equities, it has a projected volatility of 16%, or, for a simple calculation, 16 risk units.
Now, let’s assume an investor wants to take advantage of an emerging market’s selloff and allocates a quarter of the equity sleeve accordingly.
With a projected volatility of 24%, or 24 risk units, emerging market equities carry considerably more risk than U.S. stocks. Adding the 25% allocation assumes six risk units for the emerging markets allocation (24 risk units x 0.25) and 12 risk units for the U.S. large-cap equity portion (16 risk units x 0.75).
In this example, the client’s equity allocation now carries 18 risk units, far greater than its initial 16. The portfolio’s return potential may have been boosted by adding emerging market equity, but so too, has the portfolio’s risk.
The challenge is to bring the client’s portfolio back to its original risk level without sacrificing the return potential they sought to improve.