The investment process is framed by reference to a risk budget aligned to the investment.

A risk budget is the amount of investment risk, relative to liabilities, an investing institution wishes to take. Risk budgeting is a risk modelling tool (similar to asset liability modelling) which aims to define the risk budget and allocate it among different investments in the most efficient manner. Risk budgeting typically has a shorter outlook than asset liability modelling, and can also assess how to allocate the risk budget among different types of investment management, as well as different asset classes.

Investing institutions operate in global financial markets where the management of risk and uncertainty is crucial to the creation of long-term value. Risk-taking against well-defined objectives is an essential ingredient in any well-governed financial institution. The extent to which risk-taking is a deliberate and managed activity depends upon the governance budget allocated to this function within the institution.

The risk budget concept recognizes that asset owners are required to take risks to aim to achieve the desired return outcomes. Risk budgeting provides a quantitative framework for determining how much risk needs to be taken to achieve the return objectives, what the expected reward is for each unit of risk, and the relative attractiveness of different investment opportunities and initiatives, asset classes and managers.

Once a risk budget is defined, it will be used to formulate a strategic asset allocation (as outlined in Guideline 11, Risk budget analysis and utilization) and to formulate a dynamic asset allocation reflecting extreme market valuations (covered in Guideline 12, Dynamic investing).