Janet S. Sweet

Senior Consultant

Strategically Managing Portfolio Risks

“You can only control your decisions, you cannot control the result.” While difficult to attribute to any one person, this sentiment is useful advice for institutional investors as they navigate decisions to manage the strategic risk of their portfolios.


Comprehensive risk management requires a process comprised of three elements to facilitate thoughtful decision making: (1) Identification, (2) Assessment, and (3) Strategy. It is essential that this process is conducted both at the outset of the investment program—the strategic planning stage before any investments are made—and ongoing on a regular basis. Many investment programs, both large and small, have suffered irreparable harm because not enough time was spent at the outset carefully examining what could go wrong. Further, risk is fluid and situations most threatening today may not be relevant later.

Risk Identification

The potential risks that investors face are vast and unique to each institution. Some of the common strategic risks that institutions face in carrying out their desired goals and objectives include the following types.


Downside Risk


This is likely what comes to mind when thinking about risk in portfolios. Typically defined as a negative portfolio return or a loss of value, it is actually more nuanced in the context of risk management. With downside risk, we find that the natural consideration is to avoid all downside outcomes, but actually we view this risk as one of a tradeoff. The balance is that “there is no free lunch.” In order to earn higher returns, investors must accept periods of short-term loss, and without the risk of short-term loss, it is not likely they will be rewarded with long-term growth. The choice for investors is determining how much of one versus the other is right for them.


Shortfall Risk


Shortfall risk is the risk of the portfolio not achieving the expected return, and thus not meeting the desired objective (i.e., sustainable spending). Here consideration should be given to how much of the corpus can be depleted and what other sources of inflows might be available to the organization if spending is not sustained by investment returns. A possible mitigation strategy to shortfall risk would be to balance the rate of spending with the probability of supporting that rate. For example, compare a 50% probability of supporting a 5% spending rate versus a 60% probability of supporting a 4% spending rate.


Liquidity Risk


Liquidity risk is the risk of being unable to sell assets efficiently to meet the cash flow needs of the portfolio. Here the main consideration is identifying the expected amount of cash needed from the portfolio in the short and intermediate terms and identifying the degree of certainty in the expectation. Regarding liquidity, investors must balance the tradeoff of the peace of mind that money is available every day versus accepting lower returns on investment to have that certainty. Mitigation techniques for liquidity risk involve cash flow management, ongoing liquidity analysis of the portfolio, and consideration of lending options to bridge a liquidity gap.


Inflation Risk


Inflation risk is the risk that the portfolio value—and thus spending—is not keeping pace with the rate of inflation. Here institutional investors must consider what it means to their mission if the dollars spent in the future are not keeping their purchasing power. Integration of real return asset classes is one approach to mitigating inflation effects in the short run. This tactic might be effective against the occasional spike, but a better approach may be to simply invest the portfolio in asset classes that have historically preserved purchasing power through time and be prepared for periods of high inflation that may arise from time to time.


Other Strategic Risks


Others strategic risks like Contagion Risk, the risk of all assets declining in tandem in a short period of time; Boardroom Risk, the risk of looking different that peer organizations; and, Perseverance Risk, the risk of new board members changing course or imparting differing preferences and views into the strategic plan, are also important to consider.

Risk Assessment

Acknowledging that these risks exist is a crucial element of strategic planning. Taking action to manage the risks, next requires assessing how they could impact your objectives before determining a strategy for mitigation.


Assessing what is at stake with each potential risk is imperative in order to prioritize which mitigation strategies to implement. Proper risk assessment entails both quantifying the magnitude of impact and estimating the likelihood of occurrence. Without this context, it is not possible to know where best to focus resources.


Useful ways to assess the risks described above involve modeling the potential impacts on the portfolio. Conducting scenario analysis, where different economic environments are simulated to view their anticipated effect on the portfolio, is particularly beneficial when thinking about downside and shortfall risk exposures. Cash flow simulations can illustrate the impact of liquidity and inflation risks by stress-testing withdrawal situations or demonstrating the impacts from loss of purchasing power. Asset allocation modeling and Monte Carlo simulations provide a range of expected returns and volatility over multiple time periods and provide useful insight into the role of various asset classes in the portfolio and their relation to the entire allocation.

Risk Mitigation Strategies

Risk mitigation strategies are numerous, with no “one size fits all” solution for investors. Strategies can be as simple as acknowledgment of the risk and communicating potential impact to interested parties of the institution to more complex strategies such as a derivatives-based hedge to reduce risk of a concentrated stock position. Regardless of the strategies selected for implementation, it is important to document the approach in the Investment Policy Statement including expected outcomes, possible alternate courses of action, and outlining roles and responsibilities of those in charge of executing and overseeing the strategies.


While this documentation may seem perfunctory, often it becomes the key element of a successful strategy in that it memorializes the risks faced by the institution at the time and documents the “why” for others to understand going forward. Without this context, future decision makers can be left to second-guess what has been put in place. With this context, they will be better able to evaluate the impact based on current conditions.


In closing, a key component of a successful investment program is risk management. While many commonly view risk as only downside risk, understanding that there are many types of risk to consider and manage and that it is an ongoing process provides the best opportunity for avoiding unwanted outcomes.


DISCLAIMER: This report includes candid statements and observations regarding risk management strategies; however, there is no guarantee that these statements or opinions will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.


ABOUT GOELZER: With over 50 years of experience and more than $3.5 billion in assets under advisement, Goelzer Investment Management is an investment advisory firm that leverages our proprietary investment and financial planning strategies to help successful families and institutions Dream, Invest, and Live.