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How to De-Risk Our Investment Models

Risk DialAt Model Investing we frequently receive two questions from investors:

  1. Is your investment approach conservative, moderate, or aggressive?
  2. If I’m close to, or in retirement, how do I adjust your recommendations to accommodate my lower risk appetite?

These are excellent questions, and we’ll address each one below. As you’ll see, the answers to both of these questions are related, and require a basic understanding of the evolution of portfolio management to answer appropriately.

Let’s begin by addressing the first question. In order to do this, we need to understand exactly what these terms (conservative, moderate and aggressive) really mean.

In the context of investing, these terms refer to how much risk an investor is willing to take in pursuit of returns. A conservative investor tends to be risk averse, preferring a more stable portfolio that does not heavily fluctuate in value. On the other hand, an aggressive investor is willing to take on substantial risk in exchange for the possibility of high returns. Moderate investors lie somewhere in the middle of this spectrum.

While this may sound straightforward, the application of these risk preferences within an investor’s portfolio is where things start to get complicated. This is primarily because of the nebulous nature of risk.

The Old Paradigm of Risk

Much of the investment philosophy in use today is a byproduct of Modern Portfolio Theory (MPT), which was initially developed by Harry Markowitz in 1952. While a breakthrough at the time, a substantial amount of empirical evidence has stacked up against MPT in subsequent decades.

Read More: The Drawbacks of Strategic Asset Allocation

At its core, Modern Portfolio Theory examines the past returns and volatility of various asset classes, as well as their correlations, in order to determine an optimal portfolio that achieves the highest return for a given level of risk.

While this sounds good in theory, MPT makes a few assumptions that have proven to be incorrect in recent decades. The primary mistake is the assignment of static risk levels to various asset classes: Because stocks have historically exhibited both higher returns and higher volatility (risk) over time, they are considered to always be riskier than bonds.

Based on this (flawed) assumption, the terms conservative, moderate, and aggressive have come to represent how much of an investor’s portfolio is allocated to stocks vs. bonds.

For example, an aggressive portfolio would have the bulk of its investments (80% -100%) in stocks, with the remainder in bonds. A conservative portfolio would be structured nearly the opposite, with the majority of the investments in bonds, and the remainder in stocks. A moderate portfolio would exhibit a more balanced exposure to both asset classes.

This may sound fine so far, but there is a HUGE problem in looking at risk this way.

The Modern Approach to Risk

As mentioned, one of the major mistakes of MPT is the assignment of static risk levels to stocks and bonds. In reality, the risk levels of these asset classes are NOT constant. They fluctuate wildly over time.

As a result, a portfolio that is supposedly “aggressive” (high allocation to stocks) can become very conservative at times – exhibiting low volatility and low returns, while a “conservative” (high allocation to bonds) portfolio can become extremely aggressive – exhibiting high volatility and high returns.

If you ask us, the whole idea of distinguishing between a conservative or aggressive portfolio (based on the old definitions) is not only flawed, it’s completely misleading. So what’s the better alternative?

Let’s think about this pragmatically for a moment. If you have one dollar to invest, and you’re trying to decide where to put it to work, how would you go about making that decision?

If you’re a savvy investor, you’d answer: Wherever I can obtain the highest return per unit of risk.

Wow … bold and italics in one sentence? That must be important.

Every investment involves a trade-off between risk and reward. But that trade-off is not always even … in fact, it varies considerably.

Read More: The Risk-Return Trade-Off

Some investments will have similar risk levels, but one will have a much higher potential return. On the other hand, some investments will offer similar returns, but one will have much lower volatility (risk). In either scenario, the prudent investor will select the appropriate investment that offers the best trade-off between risk and reward. Anything else would be harebrained (that sounds nicer than idiotic).

If you’re with me so far, chances are your next question is, “How do I determine the trade-off between risk and return for any given investment or investment strategy?”

The answer lies in what’s known as the Sharpe ratio.

In 1990, William F. Sharpe, Professor of Finance, Emeritus at Stanford University, received the Nobel Prize for his work on the capital asset pricing model (CAPM), and development of what’s known as the Sharpe ratio.

Sharpe RatioThe Sharpe ratio is the industry standard measure for calculating risk-adjusted returns. This is the average return earned in excess of the risk-free rate, per unit of volatility (or total risk).

In many ways the Sharpe ratio is the end-all, be-all method for analyzing the effectiveness of an investment strategy. Said differently, investment strategies that deliver high Sharpe ratios indicate the most efficient use of capital.

Note: Similar but slightly different measures of risk-adjusted returns called the Sorentino and Treynor ratios also exist. Click here for more information on those respective measures.

At this point we’re finally ready to answer question #1 – Is our investment approach conservative, moderate, or aggressive?

The answer: All of the above.

Our investment approach is as aggressive as it can be, while still minimizing risk. At the same time, it’s as conservative as possible while still allowing for the highest potential returns. Instead of making investment decisions based on some arbitrary description of an asset’s historical volatility, we focus on achieving the highest possible risk-adjusted returns (highest Sharpe ratio) by rotating in and out of asset classes as their risk and reward profiles change.

Said differently, we focus on putting every dollar of capital to work in the most effective and efficient way possible, given the current economic and financial market environment.

De-Risking for Retirement

Okay, now that we’ve got that out of the way, let’s discuss question #2 – If I’m close to, or in retirement, how do I adjust your recommendations to accommodate my lower risk appetite?

From our discussion above, you should now recognize that when you invest a dollar following our investment models, you’re allocating that dollar in a way that maximizes your potential return per unit of risk. In other words, you’re investing to earn the highest possible risk-adjusted returns, based on our analysis of the current economic and financial climate.

That being the case, there is no way to adjust our investment model recommendations to be more conservative … they’re already designed to be as conservative as possible while still allowing for an adequate return.

But there is a way to reduce your overall risk, and we’ll get into that now.

James Tobin is an American economist who taught at Harvard and Yale, and also served on the Board of Governors of the Federal Reserve System. He was also a Nobel prize winner.

One of Tobin’s most important contributions to investment theory is known as the fund separation theorem. In layman’s terms, this theory states that investors should hold a singular portfolio of assets that has the highest Sharpe ratio, and those who want a lower risk profile should combine that optimal portfolio with risk-free alternative assets.

Here’s what that means in practice: If you’re an investor and you’re going to put capital at risk (invest it) then you should do so using the investment strategy that delivers the highest Sharpe ratio. If you want to reduce your risk, you simply put less of your total capital at risk (that is, you keep a higher percentage in risk-free assets).

The easiest way to visualize this is to pretend that your portfolio is split up into two different buckets. One is a “risk” bucket and the other is a “risk-free” bucket. Whatever amount that you’re comfortable investing in the market (the risk bucket) should follow our investment models. The rest, should be invested in risk-free assets (we’ll get to these in a moment).

So for example, if you’re a young investor, you’d likely follow our investment models with 100% of your portfolio. As you approach and enter retirement, you might reduce that amount to 80% of your portfolio, with the rest kept in risk-free assets. As you get further into retirement, you might reduce your “risk” bucket even further and only follow our investment models with 60% of your portfolio. The remainder would again be allocated to risk-free investments.

Choosing Your “Risk-Free” Assets

Okay, now that you understand how to de-risk our investment models, the next question is: Which risk-free assets should I use to do this? There are only a couple of acceptable options here, so we’ll walk through them briefly.

First, for those of you who are lucky enough to be part of the Thrift Savings Plan, your risk-free asset of choice is the G Fund. This fund offers a low but steady return without the possibility of losses.

For the rest of us, there are really only two options: cash, or individual bonds. Cash is not a great option, as any money held in cash is constantly losing purchasing power to inflation. Always remember that at 2% inflation (the Federal Reserve’s target) the dollar loses half of its value every 35 years.

So that leaves bonds. And notice above that I specified “individual” bonds, as opposed to bond funds. Owning individual bonds is very different from owning bonds funds, in which there is no guarantee or promise that you will receive your principal back. Make sure that if you go this route you use Treasury bonds (ideal) or at the very least, high-quality, investment-grade bonds.

Read More: Individual Bonds vs. Bond Funds

This article threw a lot of information at you and there’s a good chance you’re still scratching your head about some of the ideas we discussed. The good news is that we’re always available to answer any questions you may have. Simply email them to support@modelinvesting.com, use the Contact Us feature on our website, or ask us via Live Chat (7AM – 3PM PST).



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