Determine acceptable level of risk for the portfolio, based on organizational and stakeholder risk tolerances, in order to provide input to governance.

Every organization has different risk tolerances depending on their goals, objectives, and stakeholders. These risk tolerances serve as an essential base for portfolio management professionals in determining the acceptable level of risk for their respective portfolios. This article will guide Portfolio Management Professionals (PfMP) on how to navigate this critical aspect of portfolio management.

Risk tolerance in the context of portfolio management refers to the degree of variability in investment returns that an organization or stakeholder is willing to withstand. It is crucial to establish risk tolerance because it guides investment decisions, and ensures alignment with the strategic objectives of the organization.

An acceptable level of risk for a portfolio must be determined based on the strategies set by an organization. This is a matter of utmost importance because it impacts the potential returns on the investments.

Assessing Organizational and Stakeholder Risk Tolerances

Defining risk tolerance begins by understanding the needs and priority of your stakeholders. Considering the organizational goals and the stakeholders’ perspectives on risk is instrumental in determining the acceptable level of risk for the portfolio.

Establishing risk tolerance through stakeholder engagement often include:

• Individual consultation with key stakeholders.
• Initial and ongoing organization-wide surveys.
• Group discussions or workshops.

Risk tolerance cannot be fixed as it generally evolves with the organizational strategy. Therefore, a review must be performed periodically to ensure that the tolerance level is still appropriate.

Determining Acceptable Risk Level in Portfolio

Once the risk tolerance is established, the next step is to determine an acceptable risk level for the portfolio. There are several steps to take in order to achieve this, and they include:

1. Prioritize the Portfolios: Categorize portfolios based on their contribution to the strategic goals of the organization.
2. Define Risk Appetite: Risk appetite is the amount of risk an organization is willing to accept in the pursuit of its objectives. It provides an amount or percentage of risk that the organization is willing to assume in order to meet its strategic objectives.
3. Define Risk Tolerance: This is the maximum level of risk that the organization can manage without damaging its financial position or reputation. It is a limit that, if exceeded, can cause severe consequences.
4. Define risk capacity: This is related to the organization’s financial ability to absorb losses. It’s the maximum level of risk the organization is capable of undertaking considering its resources and obligations.

These steps require an understanding of the organization, its operations, resources, capacities, and objectives. In managing portfolio risk, the PFMP needs to balance risk and returns effectively.

Applying the Level of Risk to Portfolio Governance

Risk tolerance, appetite, and capacity should be embedded in the organization’s strategic direction and governance. The board and management should acknowledge these parameters and ensure they are applied across all portfolios.

The governance body needs to understand the risk parameters and interpret them in terms of the organization’s strategic direction and capability to support portfolio-level decision making. This ensures that decisions regarding portfolios maintain the balance of benefits realization, risk optimization and aligning the outstanding opportunities and threats with the overall objectives of the organization.

Organizations may use different approaches and models for portfolio risk management based on their unique environment and needs. However, it’s essential that these models provide insights and direction to prioritization, execution, and opportunity management.

Conclusion

Determining the acceptable level of risk for a portfolio is an integral part of the portfolio management process. It requires understanding the organization’s risk appetite, tolerance, and capacity, and applying this understanding to drive decision-making processes. The portfolio managers, in collaboration with stakeholders, have the responsibility to ensure that the organization’s risk tolerance is reflected in its portfolios. The choice of any investment and its inclusion in a portfolio should never be made without first considering its impact on the overall risk level of the portfolio. This approach facilitates an effective portfolio management strategy that aligns with organizational objectives and stakeholder expectations.