Balancing Act

How to Talk About Portfolio Risk

Using the right language will build confidence in your approach to risk management.
Apr 01 2019

Balancing Act

Long-term funds need to manage their portfolios to meet their long- and near-term expectations simultaneously. This challenge demands assessing risks and opportunities across multiple time horizons. However, board members and staff often use different language to communicate, especially when it comes to investment risk. This disconnect can often lead to a lack of understanding of the most important risk issues facing a fund.

Purposeful questions can bridge this divide, and focusing on the right strategic points can spur constructive conversations between the fund’s board and its staff on risk management for multi-horizon portfolios. Analyzing the current and future risks of a fund in nontechnical language can foster a common understanding of critical issues around the approach and appetite for risk.

Our consultations with Members and other risk professionals indicate that making risk oversight sessions more interactive will improve decision-making on all sides. FCLTGlobal has developed a Risk Conversation Guide that provides deliberate questions about portfolio risk for fund trustees to ask their staff. Additionally, there are several tools fund staff can use to approach trustees regarding risk scenarios. We have found that integrating these tools and questions during board meetings produces more fruitful discussions on risk strategy and a clearer understanding across the organization.

Interactive scenarios are designed to help decision-makers consider how they will respond to possible future states. This process identifies plausible scenarios and their potential impact on the fund. Simulations of risks, and the responses that result, can challenge investment beliefs and highlight possible changes to asset allocation in such scenarios. These simulations also familiarize us with our own emotions and behaviors in extreme circumstances, helping us to anticipate and “experience” those emotions and behaviors before real risk materializes. To make the most of this approach, trustees could ask:

  • What short-term risks could derail us?
  • How do we envision and consider potential longer-term risks?
  • Under what circumstances do we expect our key investment strategies to underperform?

Clarifying decision-makers risk preferences can also be effective in surfacing different perspectives. Polling trustees individually on key assumptions that are incorporated into investment beliefs and discussing them during a board meeting may highlight contrasting views. Even raising the issue of managing multi-horizon risk altogether, and understanding varying comfort levels, can be a good test for potential board members or executives. To make the most of this approach, trustees could ask:

  • What are our top three to five long-term investment risks and opportunities?
  • How do we anticipate that we will respond to significant risks?
  • Do we understand the risk preferences of individual decision-makers within our organization or among our key constituents?

A purpose-risk analysis can help funds can choose to mitigate that level of loss by understanding the associated risks. Tracking a fund against its purpose provides a probable range of outcomes, and quantifying the level of loss from which a fund could not recover can help to distinguish between short-term fluctuations and potentially catastrophic losses. For example, if a $1 billion fund would be unable to fund its purpose if it fell to $500 million, it could analyze the potential losses in each of its asset classes and determine its comfort level with its ability to stay above $500 million. To make the most of this approach, trustees could ask:

  • What risks do we choose to mitigate? What is the cost of mitigating these risks?
  • Are we being compensated for assuming these risks? Are there opportunities to benefit from these risks?
  • What level of loss would threaten our purpose?
  • Are our non-investment sources of inflows or outflows correlated to any of these risks?

To facilitate discussions about managing portfolios to both meet objectives and weather risks, we have also proposed similar discussion starters for setting objectives and strategy, measuring risk and performance, organizational structure, and decision management. While current communications around risk can fall short of addressing the multi-horizonal challenge, the themes and questions above can serve as a structure to a productive discussion on risk, move the issue onto board meeting agendas, and ultimately build internal consensus on the way forward.

Additional questions, and examples of illustrative answers, can be found in our full report on the topic, Balancing Act: Managing Risk Across Multiple Time Horizons.