You have the money to invest and now you need to decide what to invest in. Once you have identified the type of investments (cash, bonds, crypto, currency etc) you will next need to decide what portion of your money to invest in each. This decision will be influenced by how much risk you are prepared to take. This is where a risk budget comes in.
In summary, a risk budget is a method of asset allocation that combines an investor's financial goals, with their risk tolerance alongside the choice of available investments.
How to create a risk budget
There are a few key steps to creating a risk budget:
Decide what your overall risk metric is eg. ‘annual volatility percentage’
Take a view of the available investments eg. Cash, bonds, active equity investing, commodities, quantitative equity investment, etc
Calculate the risk of each, using the metric chosen in step 1
Determine the marginal contribution of each individual investment into the overall risk of your portfolio
Build your investment portfolio accordingly
Risk budget asset choices, with their volatilities, for a diversified investor
Example of a risk budget for ‘Risk Averse’ investor
This investor might conservatively choose ‘5% annual volatility’ for their overall risk metric
They opt for just 2 investments; cash and a quantitative equity strategy.
Calculate the risk of each:
Cash being riskless will have a volatility of 0%.
Let's assume there are 3 available quantitative strategies with historical annual volatilities of 5%, 10% and 20% respectively.
The investor can now come up with various strategies for portfolios combining cash and quantitative that will satisfy their 5% target risk budget volatility.
The portfolio could be built in a few different ways
Decide not to invest in cash at all, and invest all your money in the 5% quant strategy
Split your investment half in cash and half in the 10% quant strategy
Invest most of your money in cash and just a quarter of your money in the 20% strategy
Other terminology ‘Risk target’ versus ‘Risk capacity’
These two terms are closely linked and the ideal scenario is that they are aligned with each other. When they are aligned, the investor has transparent financial goals which are linked to their financial investments.
Risk target is the amount of annual volatility the investor is comfortable to take
Risk capacity is the annual volatility the investor needs to achieve their financial goals (i.e their desired annual expected return)