Before Building a Portfolio, Decide How Much Risk to Own

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Why Risk Targets Should Come Before Reference Portfolios

Every Investment Committee routinely discusses portfolios.

• Should we increase equity exposure?
• How much should we allocate to private markets?
• Should we hedge currency?
• Should we reduce duration?

These are important questions, but they all assume a more fundamental issue has already been addressed.

How much risk should the institution actually own?

Asset allocation cannot determine the appropriate level of risk; it can only reflect it. Before building a portfolio, we must decide how much risk the institution is willing and able to take over the long term. This decision precedes portfolio construction.

It begins with the mandate.

The Portfolio Is the Answer. The Mandate Defines the Question.

In a previous article, I argued that the mandate must come first.

The investment portfolio exists to serve the institution, not the other way around. A defined-benefit pension plan, an endowment, a sovereign wealth fund, and an insurance company may all invest in global equities, but they solve fundamentally different problems.

Their liabilities differ. Their stakeholders differ. Their governance differs. Their objectives differ.

So why would we expect them to have the same risk target?

A portfolio should never be replicated from another institution simply because it has produced attractive returns. It should be built to solve the problem that the institution itself has been asked to solve.

That is why the investment process begins with the mandate.

Risk Appetite Is About Intent

Once the mandate is clear, the next consideration is risk appetite, not asset allocation. Risk appetite is often mistaken for a numerical limit, but it is fundamentally a qualitative statement. It reflects the organisation’s willingness to accept uncertainty in pursuit of its mission.

Questions such as these belong to risk appetite.

• How much short-term volatility are we comfortable accepting?
• Which risks are worth taking?
• Which outcomes would threaten our mission?
• Which risks are simply inconsistent with who we are?

These are governance questions before they become investment questions. The board, senior management, beneficiaries, and other stakeholders all contribute to defining them.

But there is an important limitation. Risk appetite tells us what we are willing to accept. It does not yet tell us how much.

Risk Capacity Is About Reality

Intent alone is not enough. Institutions must also understand their capacity, which is often viewed only in financial terms.

• Can we survive a 20% drawdown?
• How much liquidity do we have?
• Can we meet benefit payments?

These questions matter.

However, institutional capacity extends beyond financial capacity. A pension fund may have the resources to endure a market decline, but its governance structure may not. Political scrutiny can increase, stakeholder confidence may erode, and the board may become uncomfortable. Decision-making can become constrained when discipline is most needed.

Similarly, an endowment with perpetual capital may have significant investment capacity but limited reputational capacity if investment decisions undermine donor confidence.

Every institution has its own constraints. Some are financial. Some are operational. Some are governance-related. Some are political. Some are reputational.

Ignoring these realities can result in investment strategies that appear optimal on paper but are unsustainable in practice.

Understanding the Liability Comes Before Building the Portfolio

Before considering a reference portfolio, we must first understand what the institution aims to finance or protect.

For long-term investors, liabilities are more than actuarial calculations; they represent the institution’s commitments, which define the investment challenge.

• Is the plan open or closed?
• Are contributions flexible?
• How stable are future cash flows?
• How sensitive are obligations to inflation?
• How much sponsor support exists during periods of market stress?

These characteristics affect the institution’s ability to bear investment risk and shape its risk capacity. Ultimately, everything leads back to the mandate: the liability exists because the institution has a purpose, and the investment portfolio exists because of the liability.

From Philosophy to Numbers

This is where I believe one important step is often overlooked.

Risk appetite is qualitative. Portfolio construction is quantitative. Something has to connect the two.

That connection is the risk target.

A portfolio cannot be built from statements such as:

• “We are long-term investors.”
• “We have a high tolerance for market volatility.”
• “We are willing to look through short-term market noise.”

These are valuable principles, but they are not investment parameters. Philosophy must eventually become measurable. The risk target is the first quantitative expression of qualitative risk appetite. It translates governance into investment design and turns institutional intent into something implementable through a reference portfolio.

This is one of the most important roles of the risk target: it is where investment philosophy becomes portfolio construction.

Risk Appetite Meets Risk Capacity

Neither risk appetite nor risk capacity should determine the risk target on its own.

An institution may have the financial capacity to take more risk than it is comfortable with, or it may aspire to take more risk than its governance, liquidity, or stakeholders can support. Neither scenario leads to a sustainable investment strategy.

The risk target balances aspiration and constraint. It reflects both what the institution aims to achieve and what it can responsibly sustain.

That balance is unique to every organisation.

Why Losses Matter More Than Gains

Traditional portfolio theory assumes gains and losses are evaluated equally, but institutional decision-making rarely follows this pattern. Large losses often have consequences beyond investment returns, such as triggering governance reviews, reducing stakeholder confidence, influencing contribution policy, and constraining future investment decisions.

Behavioural finance shows that losses are felt more intensely than equivalent gains. This does not mean institutions should become short-term investors or let loss aversion dictate tactical asset allocation. However, downside outcomes deserve particular attention when defining the long-term risk target.

The goal is not to eliminate losses, but to define a level of loss the institution can tolerate without compromising its mandate.

Only Then Comes the Reference Portfolio

The reference portfolio becomes meaningful only after the risk target is established. Its role is not to determine risk levels; that decision has already been made.

Instead, the reference portfolio serves as the most efficient long-term expression of the chosen risk target. Asset allocation, implementation, and portfolio management follow. All subsequent steps depend on making the right initial decisions.

Looking Ahead

If the mandate defines the question and the risk target defines the amount of risk the institution is prepared to take, the next question naturally follows:

How should that risk be expressed?

That is the role of the reference portfolio.

In my next article, I will discuss why I see the reference portfolio not as an asset allocation exercise, but as the bridge between institutional objectives and investment implementation.