Risk management beyond investments: 5 ways to evaluate risk

As we look back on 2020, and think about how it’s been a turbulent year in many ways, it gives us reason to pause and think about how we might do things differently in 2021. While there are endless points to discuss, I am specifically going to focus on the risks we take in our investment portfolios.

As stewards of these assets, it is our responsibility to ensure we are meeting our fiduciary duties and understanding how much risk we take on in search of higher return. That’s why it’s critical to include a portfolio risk analysis as part of your going strategy and governance process. This type of exercise should have prepared you for the sudden market decline earlier this year. Knowing your risk tolerance allows you to quantify that the free fall was within the realm of your portfolio’s return distribution.  

While we traditionally use the risk management process to evaluate stats like the standard deviation and Sharpe ratio within a specific investment portfolio, I encourage you to consider the big picture and an overall governance system that works towards achieving your mission. After all, the greatest risk is that of not meeting your long-term strategic objectives and fulfilling the mission. 

Here are 5 of other ways to look at your portfolio’s risk. 

1. Focus on key variables – There are endless assumptions to make about the markets and your foundation’s future scenarios. But a few key levers directly impact our asset allocation and portfolio construction decisions: spending, inflation, risk tolerance, and liquidity preference.  Your evaluation should look at how these levers interact to influence our strategic asset allocation.  
2. Examine some comparative options – There’s nothing like a side-by-side comparison to help identify the incremental impact of change. So whether you are considering a couple of small changes to your current allocation, or thinking about changing direction altogether, it is important to look at different ways to get to those goals and understand how they are different. For example, one way we do this for clients is by comparing 4 portfolios to their current portfolio.  We show two with smaller, incremental allocations shifts against two with more aggressive allocation in seeking a higher return. The scenarios are endless, but comparing points can help your set your risk parameters. 
3. Evaluate the outcomes – When you build a portfolio, there will always be some assumptions, like what are the return and correlations of the various asset classes you are using.  From there, you should be able to conduct a Monte Carlo analysis to show you the probability of what those returns might look like in a given year, as well as across longer time frames.  
4. Think strategically – The risk of losing value and suffering from poor returns decreases when viewing a longer time frame. And most nonprofits are meant to live a very long time. So think differently about the risk within a one-year time frame, versus how that plays out across a 10- or 20-year time frame.  
5. What’s the immediate risk? – While we look for possible outcomes down the road, we can’t ignore immediate stress tests. There are countless scenarios, and some may be more relevant to your portfolio. 
   
   - What happens to your portfolio if we see a sudden market crash? If inflations jumps, or there’s an oil shock?  
   -  How do these shorter term shocks impact your near term spending? Have you considered your liquidity profile?  
   
   -  Are you still in compliance with your Investment Policy? Does that impact any debt covenants you need to monitor? 
   
   -  If you are an educational institution, there are even more variables and scenarios that should be tested (see my blog, "Planning for Times Like Today: How two universities applied enterprise financial risk analysis" for sample public and private university analyses-link to ERM).  

There’s no crystal ball for our future. But conducting a thorough analysis, from both the short term and long term view, is critical in understanding the various risks you have embedded in your asset allocation. Having a sense of what the possible results are will not only help to relieve anxiety as we continue on this market rollercoaster, but also will help satisfy your fiduciary responsibilities to the beneficiaries of these assets. The best we can do is constructively and comprehensively examine the data and apply some qualitative reasoning to give us a sense of the direction we need to take to move forward. Bring on 2021!

Information provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company. Investing involves risk including possible loss of principal. There can be no assurance that your investment objectives will be achieved nor that risk can be managed successfully. 

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only and should not be interpreted as legal opinion or advice.

Standard deviation is a statistical measurement in finance that, when applied to the annual rate of return of an investment, sheds light on that investment's historical volatility. Sharpe ratio describes how much excess return you receive for the extra volatility you endure for holding a riskier asset.