Most people think that the key focus at the State of Wisconsin Investment Board is to "make money". However, equally important is managing risk -- and that means focusing on the aspects of investing that can be controlled. A solid understanding of risk in its different forms allows SWIB to better understand opportunities, trade-offs and costs involved with different investment approaches, and increases the chances that we will make money.

Risk can often be thought of as something to be avoided. However, every investment involves some degree of risk. Successful investors make informed, intelligent decisions to ensure they are rewarded for the risk they take. Our challenge is to limit risk exposure to an acceptable level while still capturing solid returns.

What Is Risk? 
While SWIB considers many different types of risk, several are larger than others. In finance, risk can be defined as the probability that an investment return will be different than expected. Risk can be close to zero, as in the case of a U.S. Treasury security, which is backed by the U.S. government. Risk can be very high, such as owning real estate in a developing country. Generally, assets with higher risks are expected to generate higher returns.

SWIB monitors other types of risks associated with the Wisconsin Retirement System. Risk management takes into account how it all works together. The largest types of risk include the following:

  • Market risk is the chance that investments can lose value because of a market decline. Diversification increases the chances of having a portion of your investments performing well at any given time. Market risk is one of the most difficult risks to manage for the WRS.
  • Interest rate risk is the possibility that interest rates rise, causing bond prices to fall. Long-term bond holdings in financial, utility and telecom stocks are most sensitive to interest rate risk.
  • Liquidity risk is the chance that an investor would not be able to sell an investment in an orderly fashion at the time the proceeds are needed to pay pension benefits, without the risk of loss.
  • Funding risk, or the ability to meet pension liabilities, is the most fundamental risk for the WRS. Funding is the basic measure of the system's ability to pay promised benefits to members. The WRS actuary and SWIB's asset allocation consultant agree that the WRS is positioned to meet its current and future obligations.

How Do We Manage Risk? 
SWIB has focused on risk management throughout its existence. However, with increased market volatility, monitoring risk has become even more important. Volatility is the amount of uncertainty about changes in an investment's value. Reducing volatility and minimizing annual fluctuations in Core Trust Fund returns helps to stabilize required contributions by employers and employees as well as adjustments paid to retirees. The significant market drop in 2008 was a catalyst for implementing new ways to manage the risk associated with SWIB's investment in public stock markets.

How does SWIB manage investment risks? The first step is to determine risk for a given level of expected return by carefully choosing the proportions of various assets, including stocks and bonds. This process is called asset allocation. SWIB's Board of Trustees sets asset allocation targets, with the help of modeling developed by a board-appointed consultant. Once the potential return and risk for various asset mixes are calculated, trustees select the mix of assets that should provide the optimum balance of risk and return over the next several market cycles. Modeling also measures risk during extreme market stress conditions.

Diversification is one tool used to manage risk. SWIB diversifies holdings not only by asset class but also within the asset classes, for example by investing in companies that differ in size, industry and location. A diversified portfolio reflects the proverb "don't put all your eggs in one basket".

SWIB also is incorporating new investment strategies that diversify risk away from stocks, including decreasing stock allocations and substituting alternative allocations that produce similar long-term returns, but with different risk characteristics than stocks. Because there is a tradeoff of less market risk (stock volatility) for increased liquidity risk, new monitoring tools have been developed by SWIB to enable the assessment of all cash needs. As always, market conditions are considered as changes are contemplated.

At SWIB we work hard to do three things: make money, control costs and, yes, manage risk. Each is important in helping to keep the WRS one of the most well-funded public pension systems in the country.