Risk Budget Concept
The concept of a risk budget is a useful one. It relates to how much capital, within "reasonable" probability, are you prepared to put at risk, while seeking to earn a higher return than cash.
Reminder of the logic of portfolio theory + risk budget
Investors can somethings hope to only ever invest in places where they will definitely get a reasonable return. However, in reality:
-
every time we seek to invest (i.e. every time we risk our capital) we are hopefully putting our capital in a place that has a reasonable probability of getting a better return on cash over a certain time-frame.
-
No one investment is an absolutely certainty over any time-frame. That is one of the very strong messages from investment history.
-
And diversifying between a range of investments (each of which has a good probability of a better return than cash over a certain time-frame), is one technique that we use to try to reduce investment risk.
One of the other tools in our investment tool-kit is the risk budget concept.
-
Risk tolerance = the preparedness to risk losing capital while pursuing a higher return than cash.
-
Risk-averse investors (those with a low tolerance of a negative return) have only a small “risk budget” to “spend” when investing.
-
Aggressive investors (those who have a high tolerance of a negative return) had a large “risk budget” to spend.
-
We can choose to spend our risk budget on a larger number (amount) of investments with lower risk OR on a smaller number (amount) of investments with higher risk AND still have the same overall portfolio risk.
-
If our portfolio is 100% cash, this means that either:
-
we have no tolerance for risk OR
-
we can currently find no investments with an acceptable level of risk OR
-
we may be applying Jeremy Grantham’s (https://en.wikipedia.org/wiki/Jeremy_Grantham ) investment philosophy of, in periods of extremely high investment risk, “waiting for the good cards”.
-
In this context, it is useful to also remind you of Marc Faber’s comment on 1/9/2020 that “Great Investors have Discipline and Patience”.
-
-