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. Today, let’s focus on the difference between “balanced risk” and “minimal risk.” Portfolio Risk In portfolio construction, return should always be considered within the context of its risk. The highest-returning asset classes are private equity and venture capital at returns traditionally around 10% per year. However, they come at the expense of higher risk. Private equity’s extra returns are largely a product of the amount of leverage that is used to buyout companies. To some extent, returns can also come from fixing up their inefficiencies or driving synergies from merger/acquisition activity. The higher returns in venture capital are associated with startup companies with higher growth trajectories. But volatility is high because future cash flows are generally very difficult to predict. These asset classes can often have around twice the expected risk as US public equities when taken on aggregate. This means that for someone managing a multi-asset portfolio who wanted exposure to the diversified sources of alphas that these asset classes bring, they would likely weight them low relative to something like TIPS where the return is materially lower but the return-to-risk ratio looks more favorable. Balanced Risk vs. Minimal Risk There is a difference between a portfolio that has “balanced risk” versus a portfolio that has “minimal risk.” Balanced risk means weighting portfolio components in such a way to eliminate environmental bias and using data to plot out a curve that shows the point at which return is maximized relative to risk. You can do this with as many different asset classes as you want, run a risk decomposition, and determine what the weights should be to find the right combination. Minimal risk entails the portfolio where risk is lowest and unleveraged return is not a factor. Most would assume this is a portfolio of simply cash or a short-duration safe bond. However, this is not the case because this brings on concentration exposure, both with respect to the instrument itself and FX risk. Setting Things Up To run a simple experiment, we can find what combination of stocks and bonds provide the best combination to derive both “balanced” and “minimal” risk using just two assets – US stocks and the US 10-year Treasury bond. Risk will be taken as the annualized volatility of each and their returns will be forward looking – about 7% for US stocks and 3% for the 10-year. Gold is anchored at a 5% allocation; because of its diversification benefit, both risk and return-to-risk ratios are improved throughout regardless of the allocation to stocks and bonds. Gold has been covered in other posts in the past (Gold Is Getting Cheaper – Buy It?), so there’s no need to dedicate a lot of space to it. Its future return is entered at a modest 1.6% annualized. (Historically, gold does slightly better than cash.) Balanced Risk In terms of balanced risk, we’re looking for the greatest possible amount of return per unit of risk using the constraints of balancing just these two assets. We know stocks over the long-run give around 7% annual returns and 15% annualized volatility while 10-years will give 3% annual returns at 8% annualized volatility. Some combination will provide the right balance. We can backtest different combinations to find what annual volatility was found for each portfolio. We can then pair these allocation weightings to each asset class’s estimated forward returns to find the best reward-to-risk ratio. The results are as follows: Reward-to-risk, considering a portfolio of US stocks and the US 10-year and gold anchored at 5%, is maximized at an allocation of 40% stocks and 55% bonds. Of course, this allocation would change depending on the type of bond. For a bond of lesser duration (with equal credit characteristics, such as a two-year or five-year Treasury), the allocation toward stocks would be lower in favor of more for bonds. For a bond of higher duration, more would go toward stocks and less for bonds to balance the risk. The 40% stocks / 55% bonds / 5% gold portfolio provides a Sharpe ratio improvement of 33% over a 100% stocks portfolio. The Sortino ratio improvement is 43%. Sortino provides more emphasis on downside risk than Sharpe, and thus will look more favorably on portfolios that limit their drawdowns. It’s important to emphasize that this portfolio is certainly not better in terms of absolute return. On an unleveraged basis, it would expect to earn about 4.5% annualized. However, it is doing so at about only half the volatility of the stock market. If one were to leverage this portfolio back up to a level that matched the volatility of stocks (a factor of 1.94x), this portfolio would return closer to 8.8% annually before factoring in any leverage costs. Returns would also be more linear over time because of the lack of dependency on one particular market environment. The maximum drawdown of the 40/55/5 portfolio since 1971 (when the US went off the gold standard) has been 15.4%. This was related to the 1973-74 oil shock, which hit both stocks and bonds because of the inflationary element, but benefited commodities including gold. It had a 13.3% drawdown during the 2007-09 recession. The 100% equities portfolio has sustained three drawdowns of at least 45% since then – 1973-74 oil shock, 2000-02 dot-com crash, and 2007-09 recession. When 45% is lost, that requires an 82% gain just to get back to breakeven. Minimal Risk One might be inclined to believe that for the minimal risk portfolio it would be the one that puts the most money into the 10-year bond since we know that this is a safer investment than stocks. But that actually isn’t the case because stocks provide a diversifying element in their own right. US Treasuries have a particular environmental bias where they tend to perform well in lower-growth, lower-inflation environments. On the other hand, stocks do better in an environment where economic growth exceeds any excess inflationary pressure. This is generally when there’s a reasonable amount of slack in the labor market, rates are low and thus consumption and investment activity is incentivized, and inflation isn’t a problem. The two act to counterbalance each other and better create a portfolio that isn’t too dependent on any given type of economic environment. Therefore, you’ll find that adding some amount of stocks to a bond-heavy portfolio can actually improve not only reward-to-risk metrics but pure risk metrics as well. You can see based on the graph below that risk is minimized when stocks are added in about a 20% allocation, with US 10-years at 75% and gold at 5%. If we used 30-years, the stock allocation would be higher because of the higher duration risk contribution from the bonds. If two-years were used, stocks would be lower. The long-run return of this unleveraged portfolio would be 3.7%. It has about 46% of the volatility of a stocks-only portfolio. Leveraging this back up to the volatility of the stock market would provide a long-run return of 8.0%, excluding leveraging costs. WhoTrades Live Portfolios Getting exposure to bonds can either be done through buying the bonds themselves or bond ETFs. The former is generally preferable to minimize cost and avoid the bid-ask spread issues that reduce what they ultimately pay out to you. In certain circumstances, bond ETFs can make sense. 1) This trader has hundreds of assets in his portfolio, with bond ETFs a small portion of it. (Source: WhoTrades Live Portfolio Page) 2) This portfolio follows the general idea of weighting bonds a bit higher than stocks with some other diversifiers thrown in in the form of commodities. Unleveraged long-run yield of this portfolio is expected to come in around 4.5% per year. With 2x leverage, 9%, excluding any financing costs. (Source: WhoTrades Live Portfolio Page) 3) This portfolio uses one of the first corporate bond ETFs on the market, LQD (dating back to August 2002). Precious metals are also used in a lower quantity. The portfolio is up around 40% over the past year. (Source: WhoTrades Live Portfolio Page) Conclusion “Balanced risk” pertains to maximizing reward versus risk. You do this by having a certain structure to the portfolio by combining different asset classes in the most optimal proportions possible. Therefore, even if you get the alphas wrong – or the securities or instruments you choose to deviate from the returns of an indexed portfolio of stocks, bonds, etc. – the damage won’t be as bad from poor asset selection or timing because your environmental bias is limited. “Minimized risk” is straightforward in the sense of minimizing risk through a combination of different assets. WhoTrades Live offers a vast array of portfolio ideas and strategies in how to manage your wealth. Each profile shows full transparency over virtually everything you need to know to make a decision as to whether it fits your personal money management needs and expectations. This includes returns, drawdowns, performance trends, holdings and percentage allocations, a computer- and/or user-generated synopsis of the trading style, popularity based on follower count, and any relevant trading activity.