A Step-by-Step Guide to Risk Budgeting

By: Lauren Gellhaus, Wilshire

A practical guide to risk budgeting that explains how to allocate and monitor portfolio risk to align with objectives, enhance governance, and optimize returns.

Risk budgeting is a disciplined framework for allocating and managing risk across a portfolio, aiming to maximize excess return while aligning with organizational objectives. This guide outlines the key steps and best practices for establishing and implementing a risk budget.

What is Risk Budgeting?

Risk budgeting involves setting risk limits across asset classes and balancing risk contributions rather than just capital allocations. It requires clear governance, robust measurement tools, and ongoing monitoring to ensure risks are intentional and aligned with objectives.

Key Roles in Risk Budgeting

Key stakeholders in risk budgeting — board, staff, and consultant — each have distinct responsibilities.

Implementation Steps

• Identify Investment Objectives and Risk Tolerance: Define clear objectives (e.g., return targets, funding ratios) and determine acceptable risk levels through discussion, surveys, or recommendations.
• Establish Risk Budgets Across Asset Classes: Allocate risk (not just capital) to ensure true diversification. Distinguish between allocation risk (deviations from targets) and selection risk (manager choices). Use actionable tracking error for private markets, focusing on controllable drivers.
• Outline Governance: Formalize accountability and review processes in policy documents to maintain discipline and reduce unintended exposures.
• Implement Measurement and Monitoring Systems: Use tools (e.g., Wilshire’s risk dashboards) to analyze risk contributions, track trends, and balance risk and return.
• Rebalance Dynamically: Adjust portfolios as market conditions change, eliminating unintentional tilts and monitoring intentional risks for alpha generation.

Best Practices and Considerations

• Avoid over-reliance on historical data; incorporate forward-looking models.
• Stress test risk estimates and revisit budgets periodically.
• Manage behavioral biases and complexity in dynamic risk budgets.
• Monitor contributors to active risk, such as benchmark mismatch and systematic factor exposures.

Conclusion

Effective risk budgeting is an ongoing process requiring adaptability, transparency, and collaboration. By understanding risk drivers and maintaining robust governance, investors can prudently allocate risk and pursue excess returns.

Click here to read the full paper on risk budgeting at the Wilshire website.

About the author: Lauren Gellhaus, CAIA, Vice President serves on Wilshire's client solutions teams and is the chair of the firm's ESG and Diversity Committee. She is a senior consultant, working primarily with public pension plans and she specializes in sustainability.

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