For an investor, setting an appropriate portfolio risk target is a key concept. In some self-directed accounts, 529’s, and 401K’s, investors are asked to self-assess their financial circumstances and select a risk target portfolio that is suitable for their time horizon, risk tolerance, and goals. But apart from simply providing different levels of equity exposure, what is the reasoning behind the various risk target portfolios? What is the basis for the different portfolio allocations?
To help answer these questions, it is useful to introduce Modern Portfolio Theory (MPT), a fundamental framework for understanding investment portfolios. An important outgrowth of this theory was the idea that an investor can improve risk-return results by holding different assets; In other words, diversification can improve investment outcomes. Consider the graph below which plots the risk and expected return of various assets as well as portfolios of those assets.
The little dots in the area near ‘D’ represent the expected return and risk of individual assets. By combining those individual investments in optimal allocations, an investor can achieve the risk-return results on the ‘efficient frontier’. The reason that line is called ‘efficient’ is that, for any given level of risk, it represents the greatest possible return that can be achieved by holding any combination of the individual assets. Note that the individual investments around ‘D’ are ‘inefficient’ in the sense that an investor that only holds one of those assets (or a sub-optimal mix of those assets) will be taking on greater risk without any additional gain. For instance, an investor that holds the asset closest to ‘D’ could improve his or her results by changing the investment allocation so that he or she now holds the portfolio represented by ‘B’. This would improve the portfolio by providing both higher return and lower risk.
There is much more that could be said regarding MPT, its outcomes, and its limitations, but for our purposes the general framework described above is sufficient. Now, let’s focus on three important points on the efficient frontier and distinguish how those points correspond to an investor’s risk target decision.
First, look at the dot represented by ‘A’. Notice that ‘A’ is the point on the efficient frontier furthest to the left. It is therefore the least risky set of assets that an investor can choose and is called the ‘minimum variance portfolio’. An investor seeking this low risk portfolio would likely look for target allocations labeled as ‘conservative’ or ‘conservative growth’.
Now, consider point ‘B’ which is called the ‘tangency portfolio’. It lies at the point on the efficient frontier that is tangent to a straight line drawn from the expected return on a risk free asset (like a short-term Treasury bill). This tangent line and the tangent portfolio have greater meaning within the context of MPT, but for our purposes it is important because the tangency portfolio has the best expected risk-adjusted return (as measured by a metric called the Sharpe ratio) of all the points on the efficient frontier. So from a risk-reward standpoint, the tangency portfolio offers investors the best bang for their buck. If achieving the optimal risk-return allocation is the goal, an investor would consider this type of target allocation, which might fall under the ‘moderate’, ‘balanced’, or ‘moderate growth’ label.
Last, find the dot close to ‘C’. Unlike ‘A’ or ‘B’, there is nothing within the mathematical framework of MPT that distinguishes ‘C’. Rather, I just chose a point high on the efficient frontier reflective of a high risk, high return portfolio. The goal for investors that select an allocation like ‘C’ is achieving the highest returns (and accepting the higher risk associated with that portfolio). These investors would normally look for target allocations called ‘growth’ or ‘aggressive’.
In choosing a risk targeted portfolio, the first step for any investor is to determine the appropriate risk level based on the totality of their financial circumstances and goals including their tolerance for risk. When considering risk preference and the appropriate risk target portfolio, investors should consider the framework mentioned above and then call the fund sponsor, plan administrator, or other associated financial intermediary to learn more about which of the portfolio allocations would be the best fit. By understanding the link between the desired risk-return goals and the portfolio allocations, investors can have a more meaningful discussion and arrive at the correct risk target allocation.
Have questions about setting appropriate risk targets? Email me at firstname.lastname@example.org.