In Larry Swedroe’s book, The Only Guide You’ll Ever Need for the Right Financial Plan,” Swedroe describes a strategy investors can implement in their own portfolio that can reduce risk while not reducing the expected return of the overall portfolio. His secret: Increase your allocation to small-cap and value (lower-priced) stocks while simultaneously decreasing your allocation to stocks in general.
Let’s say you have a rate of return requirement for your portfolio of 5.80%. Your long-term return expectation for bonds and stocks is 4.00% and 7.00% respectively. To achieve a 5.80% target return, you have decided to allocate 40% of your portfolio to bonds and the remaining 60% to stocks:
We’ll further assume you have just read the Credit Suisse Global Investment Returns Yearbook 2009 report and believe that over the long-term, small-cap stocks and value stocks will each return approximately 1.00% more than the overall stock market (as they are perceived to be more risky than large-cap and growth stocks). If you decide to tilt 50% of your stock allocation to small-cap and value stocks, you could be expected to earn 1% more than the overall stock market (resulting in an expected stock return of 8.00%). Since you are a firm believer in taking only as much risk as you have the ability, willingness, or need to take, you decide to lower your overall exposure to stocks to the point where the overall expected return of your portfolio equals 5.80% (in this example, this would be when your allocation is 55% bonds and 45% stocks):
The graph below shows the volatility of two hypothetical index portfolios over the past 10 years – as expected, the portfolio with the heavier allocation to small-cap and value stocks (but a higher allocation to bonds) had lower volatility:
Sources: MSCI, Dimensional Returns 2.0
As can be seen in the table above, the volatility of the portfolio has been reduced (6.06% relative to 7.25%) while the expected return has not. In this example, the expected rate of return of 5.80% was almost identical to the actual rate of return of 5.84% (please do not expect this type of result going forward...expected returns are just that...expected).
If you are a risk adverse investor (as most of us are), the strategy of reducing your stock exposure while increasing your small-cap and value exposure may be appropriate. The downside risk of loss is also reduced (as can be seen in the table above for the lowest 1-year return of Portfolio 2 relative to Portfolio 1), giving additional incentive to consider implementing a similar portfolio.