Managing Risks in Institutional Portfolios

Abstract

Conventional risk management frameworks for investment portfolios rely on a set of mostly mathematical methodologies that make strong assumptions about the long term behavior of asset prices. These assumptions are based on the modern finance belief that there exists a long term, albeit stochastic, equilibrium in the markets and in the economy. The recent recurring market downturns (1999 and beyond) have exposed clear problem with the conventional approach.

This article takes a critical look at several anecdotal aspects of the real markets and attempts to define a number of useful characteristics that a modern risk management framework should possess. One particular distinction is made between 'risk management' vs 'risk measurement'. The main conclusion of this article is that developing an effective risk management process for investment portfolios is less about developing sophisticated mathematical 'risk measurement' tools and more about making honest assessments about the assumptions used to build the portfolio and creating processes to deal with purely unknowable future events.

Keywords: risk management, asset allocation, portfolio management

JEL Classification: G32, G11