Capital Allocation ≠ Risk Allocation

Eric Stein, CFA
Senior Director, Investments

What percentage of the overall volatility (or risk) of a 60% equity / 40% (i.e. 60/40) fixed income portfolio actually comes from the fixed income component? If you believe the answer is around 40%, keep on reading. If you can’t believe the percentage is actually around only 1%, you absolutely must continue reading.

Investors often make the mistake that their capital allocation, or percentages invested in each asset class, is similar to their risk allocation, or risk budget. This is simply not the case. Let’s recap a few main points. First, core fixed income investments have had lower volatility versus equity investments over time. Hence, when we say that risk and return are related we can imply that we expect equity investments to have higher returns over time versus core fixed income investments as they have more risk associated with them. As such, investors devote certain portions of their portfolio to fixed income to lower the overall volatility of the portfolio. However, even when the overall volatility is lower, the percentage of volatility or risk coming from the fixed income investments is generally still much lower than what most investors suspect.

Let’s go back to the example 60/40 portfolio discussed earlier. If you were to open up your portfolio statement you would most likely see a capital allocation pie chart that looks very well diversified (see Capital Allocation chart below as an example). The portfolio’s equity allocation is comprised of domestic large cap and small cap, international large and small cap, emerging markets, REIT’s, and commodity components and the capital allocation to fixed income is shown as well (shaded in yellow). Unfortunately, the capital allocation pie chart only provides some of the story around diversification; the rest comes from the risk allocation story that is often either untold or misunderstood. As you can see, there is a great difference between the capital allocation and risk allocation charts below for the same sample 60/40 portfolio. For this sample 60/40 portfolio the overall expected annualized volatility is 9.75%. However, if you were to decompose where the expected 9.75% of annualized volatility is coming from, the 40% fixed income capital allocation drives around only 1% of the volatility or risk allocation (also in yellow in the risk allocation chart below), meaning the other 99% of the risk allocation comes from the remaining 60% capital allocation to other “risky” assets, which are mostly equities in this case ¹.

Source: Morningstar Encorr

The process of identifying, measuring, and spending volatility (or risk) is referred to as risk budgeting. Risk budgeting is equivalent to budgeting your household. For example, let’s say you have $20,000 to spend monthly. Based upon certain variables you will determine how much of your budget will be allocated to your home, cars, savings, travel, and entertainment. The more you spend on one variable, the less you have to spend on the others. Risk budgeting is very similar in that you have both a limited risk budget and you have to efficiently allocate that risk among the various asset classes.

As mentioned earlier, investors can change the overall level of risk of the portfolio, which is often done by investing more in fixed income, but the greatest percentages of risk are spent on the other “risky” assets that are found in the portfolio (remember that risk and return are related). As we will now show, this is true until the portfolio is extremely weighted towards fixed income. Looking at the chart below we show three different sample portfolios ranging from 40% in capital allocation in fixed income to 80%. What is quite noticeable is how the overall level of expected volatility decreases as the capital allocation to fixed income increases. However, even in the 20/80 portfolio where this is an 80% capital allocation to fixed income, only 40% (still less than half) of the risk is derived from that position (meaning the 20% equity allocation drives 60% of the risk budget). This should be expected as we know that equity investments are expected to be riskier assets versus fixed income.

The understanding of capital allocation vs. risk allocation is important on several fronts. First, it is critical to understand how you as an investor can lower your overall expected level of volatility. As shown, one way is by allocating more assets to fixed income. Another potential opportunity to lower overall portfolio volatility is through the use of a prudent allocation to certain diversified alternative investments. Second, similar to your household budget, it is crucial for investors to understand that your risk dollars are being allocated and spent efficiently. It is the appropriate allocation of risk, not capital, that is the key to diversification. Said differently, appropriate diversification does not occur simply because you have allocated to the different Morningstar style boxes.

This report is for illustrative purposes only. Past performance is not indicative of future results. The performance numbers displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. The indices discussed are unmanaged and do not incur management fees, transaction costs or other expenses associated with investable products. It is not possible to directly invest in an index.

¹Risk budgeting is a quantitative process that provides a mathematical framework to the portfolio construction process that includes the identification and quantification of the sources of risk. Part of this process is the calculation of marginal contribution to risk, which allows one to not only approximate the change in portfolio risk due to a change in the weighting of an individual holding but it also allows for the determination of which positions are least optimal. Litterman, Robert, and the Quantitative Resources Group, Goldman Sachs Asset Management (2003); Modern Investment Management: An Equilibrium Approach.

Wealth Management Disclosure