The role of correlation in risk profile portfolios

This article unravels the fundamentally different roles of correlation when building risk-based portfolios by means of either risk control or risk contribution. We focus on the case of a portfolio manager who aligns the riskiness of the portfolio with the risk profile of the investor through a varying combination of equity and bonds. Risk control is shown to reduce exposure to equity in case of poor asset class diversification, while risk contribution does the opposite. Portfolio managers who consider building their balanced portfolios on either of these risk-based techniques will find this insight valuable.