Lesson 4 of 7 · 14 min
Risk tolerance and risk budgeting
Risk tolerance says how much loss and failure the organisation is willing to accept; risk budgeting then quantifies that tolerance in specific metrics and allocates it across activities, forcing every decision to earn its share of the risk.
In short
- Risk tolerance (risk appetite) is the extent to which the organisation is willing to experience losses or opportunity costs and fail to meet its objectives. It is set by the board, ideally before a crisis.
- It combines an inside view (what shortfalls would make us fail?) and an outside view (which risk drivers are we exposed to?).
- Should drive tolerance: goals, expertise, strategy, ability to respond to adverse events, loss capacity as a going concern, competitive and regulatory landscape. Should not (but often does): board members' beliefs and agendas, company size, a calm market, short-term pressure, management pay.
- Once tolerance is set, risk management aims to keep risk exposure in line with risk appetite.
- Risk budgeting is any means of allocating investments or assets by their risk characteristics. It quantifies and allocates tolerable risk; it does not set the target return.
- Order: risk tolerance → risk budget → risk exposures. Budgets can be one-dimensional (standard deviation, beta, VaR, scenario loss) or multi-dimensional (risk classes, risk factors).
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