In asset allocation planning, the decision on the amount of stocks versus bonds in one’s portfolio is a very important decision. Simply buying stocks without regard of a possible bear market can result in panic selling later. One’s true risk tolerance can be hard to gauge until having experienced a real bear market with money invested in the market. Finding the proper balance is key.
Risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk. Return refers to either gains and losses made from trading a security.
The return on an investment is expressed as a percentage and considered a random variable that takes any value within a given range. Several factors influence the type of returns that investor can expect from trading in the markets.
The risk associated with investments can be thought of as lying along a spectrum. On the low-risk end, there are short-term government bonds with low yields. The middle of the spectrum may contain investments such as rental property or high-yield debt. On the high-risk end of the spectrum are equity investments, futures and commodity contracts, including options.
Investments with different levels of risk are often placed together in a portfolio to maximize returns while minimizing the possibility of volatility and loss. Modern portfolio theory (MPT) uses statistical techniques to determine an efficient frontier that results in the lowest risk for a given rate of return. Using the concepts of this theory, assets are combined in a portfolio based on statistical measurements such as standard deviation and correlation.
Diversification allows investors to reduce the overall risk associated with their portfolio but may limit potential returns. Making investments in only one market sector may, if that sector significantly outperforms the overall market, generate superior returns, but should the sector decline then you may experience lower returns than could have been achieved with a broadly diversified portfolio.
The correlation between the hazards one runs in investing and the performance of investments is known as the risk-return tradeoff. The risk-return tradeoff states the higher the risk, the higher the reward and vice versa. Using this principle, low levels of uncertainty (risk) are associated with low potential returns and high levels of uncertainty with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.
Investors consider the risk-return tradeoff as one of the essential components of decision-making. They also use it to assess their portfolios as a whole.
An investor needs to understand his individual risk tolerance when constructing a portfolio of assets. Risk tolerance varies among investors. Factors that impact risk tolerance may include:
- Future earnings potential.
- The size of the portfolio.
- Ability to replace lost funds.
- The presence of other types of assets: equity in a home, a pension plan, an insurance policy.
- The amount of time remaining until retirement.
Problems with asset allocation
- Investors agree to asset allocation, but after some good returns, they decide that they really wanted more risk.
- Investor behavior is inherently biased. Even though investor chooses an asset allocation, implementation is a challenge.
- Investors agree to asset allocation, but after some bad returns, they decide that they really wanted less risk.
- Security selection within asset classes will not necessarily produce a risk profile equal to the asset class.
- Investors’ risk tolerance is not knowable ahead of time.
- The long-run behavior of asset classes does not guarantee their shorter-term behavior.
Risk and Return Models
- Proxy models
- Multifactor model
- Accounting and debt-based models
- The Capital Asset Pricing Model (CAPM)
Managing Risk and Return
Formulas, strategies, and algorithms abound that are dedicated to analyzing and attempting to quantify the relationship between risk and return.
Roy’s safety-first criterion, also known as the SFRatio, is an approach to investment decisions that sets a minimum required return for a given level of risk. Its formula provides a probability of getting a minimum-required return on a portfolio; an investor’s optimal decision is to choose the portfolio with the highest SFRatio.
Another popular measure is the Sharpe ratio. This calculation compares an asset’s, fund’s, or portfolio’s return to the performance of a risk-free investment, most commonly the three-month U.S. Treasury bill. The greater the Sharpe ratio, the better the risk-adjusted performance.