A process control approach to investment risk

The problem of misdirected investment strategies based on erroneous forecasts is the motivation for a Process Control (PC) approach to volatility and risk. Upper and lower limits on the capital accumulation process are used to determine if the current investment strategy continues. If a limit is reached then rebalancing occurs, where returns are re-estimated, new limits are established and a new strategy is determined. This variable planning horizon approach is compared to the standard Value-at-Risk (VaR) methodology, where the time horizon is fixed. In an application to asset allocation involving stocks, bonds and cash, it is shown that for any VaR strategy there exists process control limits so that the corresponding PC strategy has greater expected return with equivalent downside risk. The advantage in the process control approach comes from intervening when the wealth process deviates significantly from expectations.