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Risk Budgeting for Multi-Asset Portfolios
Modern portfolio theory was born in 1952 from Harry Markowitz’s seminal paper “Portfolio Selection”. For the first time the importance of the trade-off between risk and return on an aggregate portfolio level, was established. In the last 70 years risk management has evolved considerably, but it is only in the last two decades that the use of advanced risk tools became a determinant part of asset allocation, at least for the most sophisticated investors. This paper introduces the concept of risk budgeting and explains how it can be applied to portfolio construction and monitoring, to achieve a better understanding of the underlying risks and ultimately more robust and better long term portfolio performances.
The Benefit of Risk Factor Allocation
The importance of diversification is mentioned centuries before the birth of Christ (Ecclesiastes 11:2, 935 B.C.: “Invest in seven ventures, yes, in eight; you do not know what disaster may come upon the land”) and is a well understood and appreciated concept in asset allocation. Most investors, however, focus on asset diversification, which is not always equivalent to risk diversification. In this paper we show how a better risk factor allocation and, therefore, a higher diversification of risks can improve the risk-adjusted return and, more importantly, reduce the drawdown of a multi-asset portfolio, with substantial benefits for the final investors.
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