Portfolio Risk: Is It Worth Taking a Chance?

by: Lowell Herr

Knowing the return of a portfolio is highly correlated with portfolio uncertainty, is it better to go with an aggressive portfolio or is it preferable to keep the volatility down by tilting toward a conservative asset allocation? The results may be surprising.

For this test I selected an array of ETFs that would cover domestic equities, REITs, developed international markets, emerging markets, and various bond options for the conservative portfolio. Both portfolios are tilted toward the value side of the investing spectrum, so both the aggressive and conservative portfolios have a bent toward a moderate investing style.

The data table below shows the asset allocation plan for each. No bonds are in the aggressive portfolio. A much higher percentage is allocated to small cap stocks in the form of the IWM and VBR ETFs.

Using the Quantext Portfolio Planner software developed by Geoff Considine, certain assumptions are required for the Monte Carlo retirement projections. For both the aggressive and conservative portfolios, I used a projected return of 7.0% for the S&P 500, our reference frame. Inflation was set at 3.5%. The investor is 40 years old, saves $12,000 per year, already saved $250,000, expects to retire at age 66, and will retire on an annual income of $50,000 using current dollars.

Given the above assumptions, the conservative portfolio provides the following projections. This investor has a 10% probability of running out of money in 11 years at age 77. Of greater danger is the 50% probability of coming up short by age 90.

Note in the screen shot below, the projected return is 7.03%, or the same as that projected for the S&P 500. The projected uncertainty comes in at a respectable 13.4%. What does not show up in this data is a measurement of diversification. That value is a modest 23%, whereas the goal is to exceed 40%.

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Now we move on to the aggressive portfolio that holds no bonds. With this portfolio the investor has a 10% chance of running out of money one year earlier than the conservative investor. Statistically it is no different. On the 50% probability end, the aggressive investor moves the age out 15 years to 105. The probability of running out of money by age 90 is about 34%.

Before deciding the aggressive portfolio is superior, note the projected standard deviation. It is projected to be a very high 19.4%. Should a three sigma event occur, and the probability is high this will happen during the lifetime of this investor, can a retiree withstand a "haircut" of nearly 60%. Such losses are very painful, particularly if they happen close to retirement age.

The diversification of the aggressive portfolio at 14% is even lower than calculated for the conservative portfolio. In prior articles I mention the desired goal is to see a diversification of at least 40%.

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Which portfolio to choose? Based on the high uncertainty of the aggressive portfolio, I would select the conservative portfolio despite the rather high probability of running out of money between the ages of 90 and 100. Another option is to go back to the Strategic Asset Allocation plan and build a superior portfolio of ETFs and a few high yield stocks with low correlation to the S&P 500.

Disclosure: I am long VTI, VTV, VBR, VNQ, VEU, VWO, TIP, HYG, TLT.

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