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How much riskier is a “Multifactor” portfolio relative to a “Couch Potato” portfolio?

February 23, 2012 - 0 comments

It is generally agreed upon in the investment community that small cap stocks and “value” stocks have higher expected returns, relative to large cap stocks and “growth” stocks – the suggested reasoning behind this is that smaller companies and value companies are perceived to be more risky, leading investors to demand a higher return on their capital. Most PWL portfolios are constructed with a heavier allocation towards these two known risk factors, which begs the question: How much riskier is a multifactor portfolio relative to a market-capitalization weighted index portfolio (otherwise known as a “Couch Potato” portfolio)?

I’ve created two model portfolios with ten years of index data to simulate the historical volatility of a balanced multifactor portfolio and Couch Potato portfolio. The multifactor portfolio has a 50% tilt towards the Dimensional Vector indices (which have a larger allocation to small cap and value stocks relative to the market).

As can be expected, the Multifactor portfolio had a higher standard deviation over this 10-year period relative to the Couch Potato portfolio (7.83% versus 7.38%, respectively), but probably not to the extent most investors would have guessed. In this example, approximately 90% of the additional volatility relative to the DEX Universe Bond Index was the result of the allocation to stocks, whereas the remaining 10% increase was the result of the small cap and value tilts. If an investor is looking for the most effective way to reduce risk, they could consider reducing their portfolio’s overall allocation to stocks before they consider reducing their small cap and value tilts (in order to get the most bang for their “risk bucks”).

By: Justin Bender with 0 comments.
Filed under: Factor Investing
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