Insight post

Jun. 15, 2021

What is a Risk Budget?

Three Keys to Investor-Centric Portfolio Construction

Risk Budget

Risk budgeting is an asset allocation methodology that builds a portfolio around the idea that there is a finite limit of risk that an investor should take. In a sense, using a risk budget is similar to the idea that a prudent consumer should set monthly spending limits and will have to live within his or her means.


Risk budgeting acknowledges the fact that sometimes small positions in a portfolio are responsible for a majority of its risk. It begins with assessing the “riskiness” or volatility and correlations of the particular investment and its category or asset class. Using sophisticated math, a risk budgeting approach will determine how much of the overall, finite risk budget is “eaten up” by an individual investment. The portfolio construction approach builds around this.

So, what is a risk budget exactly?

There are three key steps to implementing a risk budgeting approach:

  1. Determining the overall amount of risk an investor is willing to accept,
  2. Measuring the riskiness of investments under consideration,
  3. Determining the marginal contribution of an individual investment to the overall portfolio risk.

Portfolio allocation is driven by aligning the total risk contributions of each asset to the desired risk contributions so that the overall portfolio riskiness matches the desired level of portfolio risk (investor risk tolerance). This approach aligns with the philosophy that the best way to achieve your return goals is to focus on risk, not return.

Why you need a Risk Budget?

Ever heard the phrase, “Investors measure return in percentages, but measure losses in dollars”?  It is fairly common to hear investors talking about their gains in terms of percentages, but when they see losses on their statements it’s generally the dollar amounts that crystalize the impact of losses.


The COVID-19 pandemic provided a wake-up call to the fact that market risk can rear its ugly head rapidly and cause losses and emotional reactions. Many post-pandemic investors realize they got a bit of a mulligan with the market’s strong subsequent rally, so it’s a perfect chance to re-assess and prepare their portfolios for the next sell-off.


Building portfolios with risk-management as the primary objective, may provide investors with a better overall portfolio construction approach. This may help them stick to their investment plan and portfolio allocations through turbulent periods.


Risk budgets serve investors need to understand how and why their portfolio ‘behaves’ in certain markets, and aligns the emotional aspects of investing with the purely mathematical.


For advisors, risk budgets can serve as an important advice and discussion tool, while fulfilling their fiduciary responsibilities.


Building a risk budget also opens up conversations about how to think about and define risk. Standard risk metrics used by financial professionals, like beta and standard deviation, are difficult concepts for the average investor to grasp. Metrics like drawdown and pain ratio define risk in terms of losses, which is how most people think about risk. In addition, there are many risk-budgeting tools that frame risk in terms of historical scenarios or easy-to-understand heuristics.

Risk Assessment Tools

Time-intensive simulations and lengthy but accurate investor risk surveys are hard to develop. Enter: risk assessment tools.


In recent years, the FinTech industry has launched a plethora of software and tools that combine investor risk profiling and portfolio risk measurement, like Riskalyze, Positivly, FinaMetrica, and more that can help determine the riskiness of investments, as well as, model scenarios to forecast potential portfolio impacts.


While they may not provide every aspect of portfolio management, these tools can provide an investor-friendly lens into portfolio risk and return. Combined with more sophisticated analysis an advisor might perform behind-the scenes, these client-facing tools are useful to building a risk budget-based portfolio.

Risk Tolerance vs. Risk Capacity

A key aspect of creating a functional risk budget is understanding the difference between risk tolerance and risk capacity. Together, these concepts can help determine the amount of acceptable risk in a portfolio of investments.


Personal risk tolerance is the amount of risk an investor feels comfortable assuming or the degree of market uncertainty an investor is willing to handle. An investor’s risk tolerance can change over time, influenced by the investor’s psychology concerning money and finances, and often varies by age, income, and overall goals.


Risk capacity, on the other hand, refers to the minimum amount of risk an investor must take in order to reach their financial goals. Risk capacity is often decided by an investor’s current income and financial resources and can also depend on one’s plans for the future.


A significant issue that many investors run into when crafting a risk-based portfolio is not ensuring that their risk tolerance and capacity are in line with each other. When the amount of risk taken (risk capacity) exceeds the level an investor is comfortable taking (risk tolerance), a shortfall can occur and make it difficult to reach future financial goals. On the flip side, when risk tolerance is higher than risk capacity, the investor may be forced to take on undue risk.


Clearly, risk tolerance and capacity are crucial factors in determining what types of investments an investor should make. The two components are measured separately, but then seamlessly combined with a target rate of return—or how much money an investor would like their portfolio to earn—to help construct a strong risk budget.

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Risk Budget Recap

Balancing risk and return is essential to building portfolios and financial plans that will help investors achieve long-term goals, and stick with along the way. Risk budgeting is a client-centric approach to portfolio construction that involves three steps:

  1. Assess the risk investors can tolerate and determine overall risk budget,
  2. Measure the risk of investments,
  3. Allocate accordingly and measure success.

Happy investing – and always keep an eye on risk!

Swan Resources & Education

Our portfolio managers and analysts are dedicated to creating relevant, educational Articles, Podcasts, White Papers, Videos, and more.

Important Notes and Disclosures:

Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms.


All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. 


There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. All investment strategies have the potential for profit or loss. Further information is available upon request by contacting the company directly at 970-382-8901 or 131-SGI-060221