The recent global financial crisis has highlighted the impact of market turbulence on the evolution and severity of risk. As investors care about extreme risks, it is necessary to re-think portfolio management systems in accordance with risk perception and risk aversion. We propose a new paradigm in which the manager sets a long-term strategic risk-return target trade-off with tight risk limits, but very flexible asset allocation constraints. The implementation of this new system, called the Strategic Global Risk-Return Allocation, is tested live with the use of the FolioMaster optimization software from Gambit Financial Solutions.
Markowitz defines risk as ‘the variance of portfolio return’. Since the publication of Mean-Variance model in 1952, many studies have shown that higher moments of distribution of returns are relevant to asset allocation decisions. In this document, we propose a risk measure derived from Expected Utility Theory that explicitly takes into account the risk perception of the investor. We also examine the relevance of investors’ risk perceptions in their portfolio allocation decisions.
By introducing KID (Key Information Document), UCITS IV is adopting a standardized and simplified approach to explaining mutual fund risk to non-professional investors. The Synthetic Risk and Reward Indicator (SRRI) methodology defines how to assess volatility equivalents for each type of fund, and recognizes the specificities of various types of investment vehicles in the process. But the SRRI methodology does not replace a proper investment profiling system. We show that the analysis of investor profiles is a necessary complement to the KID in order to provide adequate advice to investors.
Economic context and regulatory pressures have highlighted the importance of establishing a risk profile for each investor. Instead of viewing it as a cost centre, the exercise of profiling should be viewed as a valuable source of information regarding the investor’s investment horizon, risk perception and risk tolerance. The approach advocated here shows how of the personal characteristics of an investor can feed into a fully individualized portfolio recommendation.
There are many methodologies for determining an optimal portfolio allocation. In this document we list the most popular methods and compare them with a risk-preference based approach. We also provide a practical example including a backtest.
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