Three pillars for Risk Management
In order to establish sound market risk management principles for our private client investors, we rely on three pillars: risk measurement, monitoring and management (or RAIM – Risk-Adjusted Investment Management).
Pillar 1: Risk Measurement refers to the tools institutional investors use to measure risk.
Pillar 2: Risk Monitoring focuses on the process of evaluating changes in portfolio risk over time.
Pillar 3: Risk Adjusted Investment Management refers to how we at Private Office Asset Management ultimately strive to produce the highest possible returns for the minimum amount of risk and how, therefore, investors may adjust their portfolios in response to expected changes in risk.
For risk measurement, we measure aggregate portfolio risk with volatility or tracking error, which rely on individual volatilities and correlations of asset classes and managers. However, while volatility, tracking error and correlations capture the overall risk of the portfolio, they do not distinguish between the sources of risk, which may include market risk, sector risk, credit risk and interest rate risk, to name a few. For instance, energy stocks are likely to be sensitive to oil prices and BBB corporate bonds are likely to be sensitive to credit spreads.
Risk monitoring enables us to monitor changes in the sources of risk on a regular and timely basis. Here, the sources of risk are stressed to assess the impact on the portfolio. Stress testing is flexible in enabling us to gauge the impact of an event on the portfolio. Stress tests are used typically to assess the impact of large and rare events. Whereas stress tests do not address the likelihood of extreme shocks occurring, other methods for analysing tail risk do.
The third pillar in the risk management framework is risk-adjusted investment management (RAIM), which puts risk measurement and monitoring outputs into action. RAIM aligns the investment decision making process with the risk management function. For instance, RAIM might be used to make portfolio adjustments as either the correlations between assets rise or the probability of certain tail risk or disaster scenarios increases.
Robust Risk Management integrates all three areas.
On a practical level, the diagram below demonstrates the relationship between a typical client’s objectives, titled here as the Family Goal Structure (client objectives in ascending order from base to peak) on the left, and the inherent risks in Asset Allocation on the right.
In broad terms, when chasing the aggressive growth there is clearly a higher chance of loss when seeking the higher returns with aggressive growth assets. This has an inverse relationship with the family goals, where the pain of that loss is most keenly felt at the base if needs and obligations cannot be met.
The risk management process necessarily involves utilising the three pillars for risk management above, and then applying that to what matters, – the financial objectives of the client, and the risk that they are prepared to take in achieving their goals. We undertake a thorough risk profile questionnaire which is integrated into qualitative discussions settle and agree on the right balance for the individual client.