WhoTrades Live is an investment platform that puts you in charge of what traders and portfolios you invest in across a host of various strategies. On WT Live you can find thousands of these portfolios and traders by filtering by portfolio yield, trades count, drawdown, and performance history. _____ Building a Portfolio to Meet Returns Expectations Investors generally have a certain return target in mind when constructing their portfolios. For one, it has to be realistic and, two, it should ideally be achieved at the lowest risk possible. It’s also based on circumstances. For a cash-only account, achieving 12% per year over the long-run is probably unrealistic because even the highest returning asset class (equities) is only going to return about 7% per year. So you need to outperform that by deviating from an index – either by choosing the right assets and/or getting the timing correct. For a 2:1 Reg-T account, 12% returns would entail mostly investing in risk assets. Though because of the leverage embedded in risk assets and the leverage needed to boost their long-run returns above 7%, this inevitably produces periods of risk that would be unacceptable to most investors. Leveraging a portfolio concentrated in assets with embedded leverage also has the “risk of ruin” element to it. Then beyond standard leverage constraints, there’s also the cost of the leverage to take into consideration. With traditional discount brokers like Robinhood, Scottrade, E-Trade, and others, using margin accounts is not recommended because they gouge their customers on the rates. But without constraints related to the amount and cost of leverage, there is an efficient way to target low-double-digit returns per year. Even in the sense of not trying to pick specific securities or assets and simply going by passive indexing instead. This generally means going uniformly long various “betas,” or asset classes. Financial assets are expected to outperform cash over the long-run. If this assumption were not true, particularly over long periods of time, then people would not invest and capitalist economies could not operate. Asset classes with more risk are also expected to outperform lower risk asset classes over the long-run. This is because investors expect to be compensated according to the risk they take on. _____ Risk vs. Return The thinking might be, why not put everything into the highest-returning asset class and not take the risk of using leverage? The problem is that concentrating your portfolio in certain assets increases your risk exponentially, not linearly. This goes for not only individual securities or sectors, but also entire asset classes. This can be explained mathematically and described graphically, which I believe is the best way to illustrate it. If you invest in stocks, and the average stock is 75% correlated to each other, then you’re not going to be reducing your market-related risk that much after investing in about four different stocks. You reduce your risk by 10% after investing in four assets, but reduce it by only 13% by investing in 25. If you were to invest in 1,000, you’re only reducing your risk by about 14%. Or put differently, reward-to-risk is increased by 14%. If assets are 50% correlated, after 10 assets, your risk reduction is 24%. Going out to 25 improves that by only an additional two percentage points. When assets are 25% correlated, after 10 assets, risk/reward improvement is 43%. After 25, 47%. When assets are perfectly uncorrelated, you start seeing material improvement. After 10 assets, risk/reward is improved by 68%. After 25, it is improved by 80%. In other words, you’re getting 5x the return at the same risk or same return for one-fifth of the risk, or some combination in between. Is this more theoretical than doable? In terms of the universe of value-added ("alpha") bets possible, then no. In the sense of passive index investing, then yes, because only so many different asset classes exist. There aren’t 25 uncorrelated asset classes, though improving reward-to-risk by 2x-3x is feasible with the proper weighting, which I’ll describe in Part II to follow very soon. _____ WhoTrades Live Examples The portfolio below has exposure to $FLOT (an investment-grade floating-rate bond ETF) and precious metals, but is largely concentrated in equities (e.g., $HACK $PANW $AAPL $MA $C $ADBE ). This means that the portfolio has large dependence on how the broader equity market performs and having a healthy economic backdrop such that that’s possible. To be clear, this is not “criticism” because there are multiple ways to skin a cat. Just that returns will be volatile given the concentration in equities and mostly within specific sectors. Moreover, for cash accounts, there is no other means to maximize returns without going into the highest returning asset classes, as addressed above. The next portfolio has a large amount of non-equity exposure with 46% in intermediate-duration bonds ( $VCIT ) and 3%-5% allocations toward a few different commodity ETFs ( $SGGB $IAU $BCI ) and emerging market debt ( $EMLC ). The portfolio’s weighting toward equities is still relatively high at 35% ( $VT ), which means about half the portfolio will still be led by movements in the stock market. _____ Conclusion The main takeaway from this is the relationship between risk and concentrated exposure. The relationship is not linear, it is exponential. Concentrating exposure in a particular asset, sector, or asset class leads to risks that steepen in a non-linear fashion. This is different from leverage, which increases risk and returns linearly. Accordingly, a moderately leveraged, diversified portfolio can have tangibly less risk than a non-leveraged, highly concentrated portfolio. This will be explained more in Part II to follow. WhoTrades Live provides thousands of portfolios that you can view, follow, copy, and learn from. It allows you to invest on your own without being alone in the process and without the large costs associated with outsourcing managing your savings to expensive financial advisors and actively managed products.