Risk and Portfolio Construction

Risk and Portfolio Construction - Articles & White Papers

The Savvy Investor Risk and Portfolio Construction section lists academic research materials, thought-leadership pieces, and white papers on the strategies and tools used by asset managers to measure and manage portfolio risk whilst investing across a broad range of asset classes.

Portfolio construction is the process through which various assets or securities are grouped together based on an investor’s investment objectives. These objectives, such as the pursuit of investment growth or income, or a combination of the two, must be balanced with the risks associated with holding different asset classes...


For portfolio managers, market-based risk or ‘systematic risk’ is unavoidable. However, other non-systematic risks can be managed, or at least mitigated, through holding a diverse portfolio of assets whose investment performance is largely uncorrelated. The following are risk factors, which can be managed and are instrumental in asset manager portfolio construction:

  • Asset correlations
  • Market timing
  • Foreign currency
  • Benchmark risk
  • Downside risk
  • Volatility
  • Liquidity
  • Interest rates
  • Tail risk

As today’s fund managers will attest, a litany of metrics can be used to measure portfolio risk.  Savvy Investor members with an interest in statistical risk and the time horizon over which statistical risk is best measured can find white papers on these topics on our site by searching for the following terms:

  • Beta
  • R-squared
  • Value at Risk (VaR)
  • Sharpe ratio
  • Standard deviation

Following historical market shocks or ‘Black Swan’ events such as the Great Financial Crisis (GFC) of 2008/2009, the Eurozone debt crisis and the Covid-19 crash, asset allocators have naturally gravitated towards mitigating portfolio losses. This has resulted in hedging strategies that protect against downside risk and sharp portfolio drawdowns becoming ubiquitous in the institutional investment arena. According to the 2020 ECB Financial Stability Review, an estimated $2 trillion is now invested in low-volatility strategies worldwide.

Despite most defensive funds operating a quasi-passive management approach due to computer-driven trade execution, portfolio performance risks remain. The ‘Volmageddon’ event (a violent volatility spike) of February 2018 exemplified this performance risk as risk parity funds and the performance of other volatility-based strategies deviated from their respective benchmarks. Benchmark risk, as measured by tracking error, therefore illustrates that all funds whether defensive, active, or passive are likely to be subject to increasing performance scrutiny in the future.

Of course, the best blend of assets in a portfolio is never static and thus the process of monitoring and maximising the balance of portfolio risk, return and performance, known as portfolio optimisation, is an ongoing pursuit for institutional asset allocators.

As market conditions change over time, so too do risk and portfolio construction theories. This change has become more pronounced in recent years as market practitioners and academics begin to question the merits of the classic 60/40 equity/bond allocations and opt instead for progressive allocations that constitute elements of the ‘Dragon portfolio’ namely: equities, commodities, bonds, long volatility and gold

Read more