Defining Risk For Your Organization

August 17, 2015 |
1 minute read
|

Merriam-Webster’s defines risk as the “possibility of loss or injury.” The financial profession — borrowing from Modern Portfolio Theory — uses the standard deviation of a portfolio’s returns to quantify potential loss. 

But a definition that focuses solely on the assets in a portfolio and equates risk with volatility of those assets ignores liabilities that need to be funded and suffers from being too narrow to be truly useful for mission-based investors. For those investors and their organizations, risk is better defined as the possibility of failing to fund liabilities incurred in fulfilling their long-term mission.

A Case Against Focusing Solely on the Volatility of Assets

Focusing on the volatility of assets is inadequate for two main reasons. First, volatility is a price concept that focuses on market risk, ignoring the many other types of risks organizations face. While many investors are quick to think of market risk as the most likely cause of such a failure, many other sources of risk — such as liquidity risk, operational risk in the processing of investment transactions, custody risk in the safekeeping of securities, legal and regulatory risk, and outright fraud — also have the potential to diminish an organization’s returns.

Second, the asset focus ignores the obligations or liabilities that mission-based organizations have taken on and are trying to meet to further their mission. For a nonprofit mission-driven organization, risk may be best defined in a more strategic sense as the possibility of a failure to meet the organization’s implicit or explicit commitments to its beneficiaries arising from its inability to deliver sufficient cash flow to meet near-term liabilities while earning a long-term return in excess of inflation.

Asset/liability management, widely used in the pension and banking industries, is an effective form of risk management that endeavors to mitigate or hedge the risk of failing to meet institutional obligations. It warrants greater consideration as a way to manage the risks of mission-based organizations.

To learn more about an asset/liability approach to endowment risk management click here to download the full articleRedefining the Risk Waterfall.

Commonfund

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