Ever heard the phrase, “Investors measure return in percentages, but measure losses in dollars”? It is fairly common to hear investors talking about their gains in terms of percentages, but when they see losses on their statements it’s generally the dollar amounts that crystalize the impact of losses.
The COVID-19 pandemic provided a wake-up call to the fact that market risk can rear its ugly head rapidly and cause losses and emotional reactions. Many post-pandemic investors realize they got a bit of a mulligan with the market’s strong subsequent rally, so it’s a perfect chance to re-assess and prepare their portfolios for the next sell-off.
Building portfolios with risk-management as the primary objective, may provide investors with a better overall portfolio construction approach. This may help them stick to their investment plan and portfolio allocations through turbulent periods.
Risk budgets serve investors need to understand how and why their portfolio ‘behaves’ in certain markets, and aligns the emotional aspects of investing with the purely mathematical.
For advisors, risk budgets can serve as an important advice and discussion tool, while fulfilling their fiduciary responsibilities.
Building a risk budget also opens up conversations about how to think about and define risk. Standard risk metrics used by financial professionals, like beta and standard deviation, are difficult concepts for the average investor to grasp. Metrics like drawdown and pain ratio define risk in terms of losses, which is how most people think about risk. In addition, there are many risk-budgeting tools that frame risk in terms of historical scenarios or easy-to-understand heuristics.