Risk Management

Avoiding the Pendulum Portfolio

An investor’s appetite for risk often swings between very healthy and much diminished. But companies can’t afford to let that happen.
Vincent RyanJune 26, 2013

This is the fourth of four stories examining cash investing. The other three are Better Than Nothing, which profiles companies that are once again seeking a return on excess cash; Money-Market Funds Meet Their Waterloo, which looks at the latest regulatory reforms; and Beyond Money Funds: Other Places to Park Cash, which analyzes the risks of putting cash in alternate investment products.


When a company’s short-term cash investing is driven by changes in its risk tolerance, which in turn is driven by market-wide and macroeconomic trends, it not only risks a giant loss of principal; it risks losing the opportunity to earn a reasonable return.

At a lot of firms, cash investing is like a pendulum swinging back and forth from “risk-on” to “risk off.” “Risk on” was the behavior prevalent before the financial crisis, when treasurers aggressively sought yield in structured instruments like auction-rate securities. “Risk-off” is what occurred afterward — treasurers moved all their cash to Treasury bills and government-agency paper, afraid to take any risk at all.

Now, five years after the crisis, financial markets have stabilized. Naturally, treasurers want to turn risk on again. But if they haven’t done so already, it may be too late, says Lance Pan, director of investment research at Capital Advisors Group.

“They are sitting on cash earning no yield, and they feel like they have to do something,” Pan says. “But spreads have compressed so much that there isn’t much yield to pick up. The result is if they have to [earn a return], they will wind up taking more risk than [the return] warrants.”

In theory, at least, companies in this position could have moved faster if they had had an approach that let them gradually shift their portfolio to accommodate changing risk conditions but at the same time kept risk tolerance constant.  In their cash investing, companies are better off trying to “achieve more balanced portfolio risk characteristics throughout economic cycles,” says Pan.

Pan has come up with a concept that may help CFOs and corporate treasurers think about risk when constructing a cash portfolio: constant risk aversion (CRA). “We think that a ‘constant risk’ concept is warranted so that one does not slip into the binomial ‘risk-on, risk-off’ behavior often observed in all forms of investing,” Pan wrote in a paper introducing CRA.

How a CFO would apply CRA is difficult to explain. But it involves determining the “risk-seeking” behavior of a company and its finance people — how much satisfaction do they get for taking on one additional unit of risk? In addition, the company needs a measure for risk tolerance, such as what is the maximum marked-to-market portfolio value swings that a treasurer is comfortable with.

Pan gives the example of how CRA would be applied to a portfolio of one risky asset and one risk-free asset. Here’s his explanation:

“As the generic ‘risk’ in the risky asset increases, one may reduce dollars invested in the risky asset and add the corresponding amount to the risk-free asset to maintain a constant risk profile. Similarly, when the portfolio’s wealth increases or decreases, proportional allocation may be made to risky and risk-free assets so that the overall risk profile remains constant.”

A CRA cash portfolio may help “reduce nail biting and complacency,” Pan says. But it also can do two other things. First, it enables a company to account for the opportunity cost of not taking a risky action, like investing in low-grade corporate bonds. Constructing investment policies focused solely on minimizing risk does not take into account the potential benefits of taking on incremental risk.

Second, a CRA measurement keeps management from setting an absolute return benchmark for the cash investment portfolio. Most CFOs declare the objective of their investing policy to be to keep cash safe and liquid “and then give me some yield,” Pan says.

But what amount of yield is respectable? If a treasurer tries to hit an absolute number, he or she could inject the portfolio with too much risk. The better question is, given a constant risk measure, how much return was achieved? By comparing the return of two portfolios that both adhere to a company’s CRA measure, finance can figure out “if someone is doing a better or worse job” investing the cash, Pan says.

CRA won’t be a panacea for companies looking to fix their cash investing approach. But Pan says it could be a helpful indicator of when it’s time to ease up on risk and when to be more aggressive. Just mastering that subtlety would be a monumental achievement for any CFO or treasurer.


This is the fourth of four stories examining cash investing. The other three are Better Than Nothing, which profiles companies that are once again seeking a return on excess cash; Money-Market Funds Meet Their Waterloo, which looks at the latest regulatory reforms; and Beyond Money Funds: Other Places to Park Cash, which analyzes the risks of putting cash in alternate investment products.