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Lower your portfolio’s risk without lowering its expected return

February 10, 2012 - 4 comments

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

 

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.

 

By: Justin Bender with 4 comments.
Filed under: Portfolio Management
Comments
  16/02/2012 8:09:57 PM
James McDowell
Yes, it's clear and I think this article is an excellent illustration of points the PWL philosophy has been emphasizing. Even though one result was not as predicted, the fine outcome speaks loudly. I'd prefer strong outcomes to strong predictions any day.
 
  13/02/2012 5:54:59 PM
Justin Bender
Hi James – here’s how the breakdown would work (a stock can be a value and a small cap stock...which would increase the expected return...in this example, to 9.00%):

“Normal” stock portfolio = 7.00% expected return

Add a 50% value and small cap tilt in the following manner:

25% Stocks @ 7.00% return = 1.75%
25% Small Cap Stocks @ 8.00% return = 2.00%
25% Value Stocks @ 8.00% return = 2.00%
25% Small Cap Value Stocks @ 9.00% = 2.25%
Total expected portfolio return = 8.00%

It’s important to note that small cap stocks and value stocks generally make a portfolio more risky...it is the increased allocation to bonds that has lowered the volatility of the overall portfolio.

Hope this helps,

Justin
 
  10/02/2012 5:45:56 PM
James McDowell
Further to what I just sent, I note with surprise the actual returns in the hypothetical portfolios. It turns out that the bonds not only reduced the volatility a great deal, but actually outperformed stock by a wide margin. Not that this would be regular occurence, but the positive results speak for themselves in the decade just completed.

The actual results are of course even more significant than the predictions I addressed in my first posting, so regardless of the math in the predictions, your point is borne out.
 
  10/02/2012 5:24:03 PM
James McDowell
Greetings, Justin. I think you are making a valid point, but question the math in Portfolio 2, if I have understood your stated premise correctly.

By going to 50% tilt to small cap and value (which really means 50% to small cap or value, because normally a stock is one or the other), either of which as I understand you to say adds 1% to normal stock yield, it would seem that we would add 50% of the extra 1% available from either small cap or value stock, i.e. 7.5%. Looking at it another way, of the original 100% of the stock portion, 50% remains the same, yielding 7% while 25% goes to small cap, yielding 8% and a further 25% to value, yielding 8%. Thus (0.50 x 7%) + (0.25 x 8%) + (0.25) x 8% = 7.5%.

While volatility would still be less, the reduction in volatility would be less pronounced.

Now, if small cap adds 2% and value equally adds 2% to normal stock yield, then indeed I haven't understood your premise correctly, in which case the small cap and value tilt is quite a powerful strategy for either increasing yield or reducing volatility. In which case, cheers!
 



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