How much risk can you take on in your portfolio?

Written by Mark Machin | November 6, 2021

Risk can be broken into: market risk, liquidity risk, and leverage risk.

Key Takeaways

Mark Machin, CEO of Opto, former head of one of the world's largest pensions, CPPIB, and Goldman Sachs partner, explains his framework for assessing how much risk to take in a portfolio.
The main risk he and many investors focus on is market risk - how volatile is the portfolio?
Private markets tend to mute portfolio volatility but have a unique risk - liquidity. Ensuring you're liquid enough that if all asset prices tank, you still have enough liquidity to cover your liabilities is critical.
There's also leverage risk (or credit risk). This is a bit less important for advisors, but they may want to mind that unpaid liabilities can negatively impact credit scores.

Transcript

I'm Mark Machin. I was formerly the president and CEO of the Canada Pension Plan Investment Board, or CPP Investments.

Risk is the number one most important thing that people need to think about in any investment portfolio. Your appetite for risk because it's impossible to make investment returns without taking risk. And so the number one question is OK, so how much risk can I take? One of the first dimensions of thinking about risk and risk appetite is market risk and thinking about what appetite do I have for volatility in markets?

Markets are inherently volatile. Based on that, you can quantify how much appetite I have for that volatility, how much risk I can take that markets will be down 20% by next year. So you can look at historical market behavior, you can look at the percentage likelihood of a major move in markets and say, OK, I'm prepared to take this quantity of risk from a market volatility perspective.

The other two dimensions we looked at other than market risk, would be how many obligations I have to pay over the next, say, ten days, over the next year. And if everything goes to hell, do I have the cash to be able to pay that? So that's a measure of how much illiquidity I can tolerate. What do I have in reserve to pay those obligations, even if everything goes wrong in my investment portfolio?

And likewise, you could look at leverage as well. Some institutions have a credit rating they want to maintain, and they don't want to trigger various leverage limits. So if everything goes wrong, have I triggered a leverage limit and maybe on a personal front, it would be the same thing. You know, you have your credit score and you probably don't want to breach certain levels on that if everything goes wrong in your portfolio.

So thinking about market volatility, think about leverage and liquidity, different dimensions of thinking about risk. Then you've got a pretty good idea of what your risk appetite is, how much risk you should take, and you can sleep at night because even if things go wrong, you know you've still taken the right amount of risk.

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