Training · QF-1 · Lesson 04 of 05
Risk and portfolio construction
The rule
Position sizing decides how much a correct view pays and how much a wrong one costs. Most quant blowups are sizing failures, not forecasting failures.
Factor risk models
A risk model explains each asset's returns through common factors — market, sector, size, value, momentum — plus a stock-specific component. It lets a fund see how much risk comes from intended bets versus accidental factor exposure.
Optimisation
Portfolio construction typically maximises expected alpha minus a risk penalty minus expected trading costs, subject to constraints on factor exposures, position sizes and liquidity. Optimisers amplify errors in inputs, so forecasts are shrunk towards zero and constraints are deliberately tight.
- ·Neutralise market and sector exposure in equity market-neutral books.
- ·Cap single positions (e.g. 1–2% of NAV).
- ·Limit participation to a fraction of daily volume.
Position sizing
Positions are often sized so each contributes a target amount of risk, rather than an equal dollar amount. Volatility targeting scales the whole book to keep expected volatility steady.
- Target annual volatility
- 10%
- Current strategy vol (unlevered)
- 5%
- Required leverage
- 2.0x
- Market vol doubles
- Leverage cut to 1.0x
Tail risk and stress tests
Correlations rise in crises, and crowded trades unwind together, as in August 2007's quant crash. Funds stress-test against historical episodes and hypothetical shocks, and set drawdown limits that automatically reduce risk.
Kill switches
Define in advance the loss at which a strategy is cut or stopped and review it, not during the drawdown. Pre-commitment avoids the bias of hoping a broken model will recover.
Hold onto this
- ·Optimise exposure against factor and sector risk, not against a single expected return.
- ·Correlation rises when it hurts most; stress the book at historical extremes.
- ·Know the loss level at which the model is shut off, and write it down beforehand.
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Education, not financial advice. Figures may be simplified for illustration.