Balancing Risk and Reward in Portfolio Construction
A practical framework for understanding investment risk, measuring it, and aligning portfolio risk with personal capacity and goals.
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Investment risk is multi-dimensional. Volatility (the ups and downs of market prices) is the most visible form, but investors also face inflation risk, longevity risk, sequence-of-returns risk, credit risk, liquidity risk, and concentration risk.
Compensated vs. Uncompensated Risks
A well-constructed portfolio managed by an asset management firm seeks to take only those risks that are expected to be compensated by higher long-term returns, and to mitigate uncompensated or poorly understood risks.
Equity risk has historically been compensated by a premium over risk-free rates. Credit risk in fixed income has been compensated by yield spreads. Illiquidity risk in private markets has often been compensated by higher expected returns, though access and skill matter greatly. Inflation risk can be mitigated through real assets and inflation-linked securities.
Risk Capacity vs. Risk Tolerance
Risk capacity (the ability to absorb losses without derailing goals) differs from risk tolerance (the emotional comfort with volatility). An investor with a long horizon, stable income, and substantial human capital may have high risk capacity even if their stated tolerance is moderate. Conversely, an investor near retirement with high spending needs relative to assets may have lower capacity regardless of temperament.
Tools for Managing Risk
Portfolio construction tools include diversification across uncorrelated or low-correlated assets, position sizing, quality filters, and stress testing against historical and hypothetical adverse scenarios. An Investment Policy Statement that defines acceptable risk levels and response protocols provides an important behavioral anchor.
Regular reviews ensure that the risk profile remains appropriate as markets, personal circumstances, and goals evolve. The objective is not to eliminate risk—impossible and counterproductive—but to take the right risks in the right amounts for the right reasons.
Investing risk disclosure
Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money. Before investing, consider the funds’ investment objectives, risks, charges, and expenses. Contact Mahoney Asset Management for a prospectus or, if available, a summary prospectus containing this information. Read it carefully.
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