Risk Allocation and Marginal Impact

This article is contributed by William G Ferrell, CIO of Ferrell Capital Management and the author of a new course on Global Risk Academy - "From Asset Allocation To Risk Allocation"

Risk Allocation

Since Harry Markowitz introduced Modern Portfolio Theory in 1952, Asset Allocation has been accepted as the standard for investment portfolio construction.  Based on historical behavior and individual predictions, managers make return and risk forecasts for categories of investments and combine them to make the most efficient portfolio possible at that point in time.  The portfolio was based on math, the future on hope.  Time revealed the outcome for investors.

Today, technology allows us to diversify investment risk in three critical ways:

1.       Allocate the amount of risk desired for each exposure.

  • Fund the investments to meet the risk criteria. 

2.      Continually measure market changes and their impact on portfolio exposures.

3.      Change the exposures whenever necessary to adapt to market behavior.

  • Reduce or remove exposures to market turmoil.
  • Increase exposures to portfolio components with the best risk-adjusted returns.

The result is what we call “Staying in Tune with the Markets”.  This allows investors to get the best reward when markets perform well and avoid losing money during financial crises.

Narv Narvekar, the new CEO at the Harvard Endowment wrote about his adoption of a “Risk allocation framework” that “We will focus less on the portion of portfolio dollars invested and more on the portion of portfolio risk coming from those exposures.  Columbia developed such a framework in 2004 and has been very well served by it.”


Marginal Impact on Investment Risk, Returns and Sharpe’s

At the heart of Risk Allocation practice is the incorporation of incremental or marginal attributions of each investment to the risk of the whole portfolio. Individual “Contributions to Risk” are based on the percentages of each exposure to the total portfolio risk.   “Marginal Risk” attribution takes into consideration the correlations between portfolio components.  It is possible that a marginal risk may have a much larger or smaller proportional impact when deleted from a portfolio.  Considering additions to a portfolio must also weigh the interaction between existing components in the portfolio and the new entry impact. 


When the returns are added to the mix, it is possible to calculate the marginal risk-adjusted return (expressed as Marginal Sharpe) impact on the portfolio performance.  Investment opportunities with Sharpe’s lower than the portfolio may have a positive impact on the portfolio Sharpe if its correlation is sufficiently low.  By the same rule, an attractive investment may negatively impact the Sharpe of the portfolio if its correlation is high.  Further calculation of the relative reliability of Marginal Sharpe’s can be used as a powerful way to adjust allocations to favor the best investment opportunities. 

Risk Allocation and Marginal Sharpe considerations for portfolio construction and maintenance combine to provide powerful tools to adapt to market conditions as they unfold.

If you want to study more about Risk Allocation, please check out the new course developed by William G Ferrell, CIO of Ferrell Capital Management - "From Asset Allocation To Risk Allocation"
If it's a fit for you and you want to join, please hurry up - the current introductory offer is valid during the short period of time only.

As an additional bonus you will get a 1-month subscription for money . net valued at $150.


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