Risk in Your Portfolio

Barron Gati
Aug 28, 2017 · 3 min read

I’ll be posting a few different series on a variety of topics, but for now, I’ll start with a very basic portfolio construction concept that even professional financial advisors don’t always get right: Risk Allocation.

Most advisors think about how much money you’ll allocate to each asset class as if the money put in will reflect the exposure that you have to that asset class. For example, the traditional advice is that for a long term portfolio, you’ll start out when you’re young with 80% stocks and 20% bonds (forgetting for the moment that there’s better ways to develop a long term portfolio than this simplistic approach).

But what do these %s really mean. They should mean that you have an 80% exposure to the stock market and a 20% exposure to the bond market; however, that’s not really the case. Let’s take an example.

Let’s assume a traditional financial advisor recommends that you put 75% of your money into stocks, 20% into bonds, and 5% into real estate. That means that your capital allocation would look like this:

But, this view fails to take into account the correlation among these asset classes and the different risk levels. Equities tend to be risker than real estate, which is riskier than bonds. Further, real estate is much more correlated to the broader market than bonds are.

Using historical ETF data, the S&P, Investment grade bonds, and REIT funds had the following return and risk characteristics:

In addition, the historical correlations among the above funds are as follows (heat mapped such that red is closer to 1 and green is closer to 0):

Now, when we take these data into account, the exposure that 75% of your portfolio in equities buys you is actually more than it’s proportional capital allocation.

In other words, the Risk Allocation more accurately shows what your money buys you in market exposure. And the Risk Allocation looks like this:

So while you only put 75% of your dollars into equities, you’re getting a portfolio that is actually about 87% equities. Similarly, your capital allocation was 20% to bonds, but since they’re lowly correlated to and less risky than equities, they take up only about 6% in the risk allocation.

So, all told, your portfolio is less diversified than you thought. What to do about this I’ll cover in another post in this series on Portfolio Construction and as always, feel free to contact me with any questions.

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Economist | Statistician | Portfolio Construction Expert

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