Everything I read about asset allocation says that investors are very conservative and must put a significant fraction of their money into fixed income investments like bonds even though stocks have historically given much higher returns.
All of these commentators may be right about their assessment of investor psychology. Of course, this says nothing about what would be best for investors; it is just a reflection of how investors think.
Morningstar has formalized this view of investors in a formula for assessing investments. This formula calculates what they call the Morningstar Risk-Adjusted Return (MRAR). I spoke about this somewhat in a previous post. Morningstar describes it in more detail in a 4-page write-up that is no longer available online, but that's okay because all the math in their expanation tends to obscure what is going on.
Let’s look at a simple example. Suppose that each year a particular investment returns either 50% or -20% with equal probability.
A simple view of this investment is that its average return is (50% + (-20%))/2 = 15%. Morningstar’s MRAR calculation can handle different degrees of conservatism, and this simple kind of average corresponds to MRAR(-1).
Another way to look at this investment is that after two years you will probably get 50% once and -20% once. So, $1 would grow by 50 cents to $1.50, and then lose 20% of $1.50 (30 cents), leaving $1.20. The two-year return is 20%. This corresponds to an annual compound rate of 9.5%. After many years, the odds are about 50/50 whether your long-term annual return would be above or below 9.5%. This kind of average corresponds to MRAR(0).
You can think of the drop from 15% to 9.5% as a penalty for volatility. And this high penalty is appropriate. This is a very volatile investment.
But Morningstar thinks that the volatility penalty should be much higher than this to match the “risk tolerances of typical retail investors”. I’m not sure, but I think “retail investors” is a reference to dolts like you and me. Presumably, professional money managers have different risk tolerances.
Morningstar says that the typical investor is so conservative that we should use MRAR(2), which gives a risk-adjusted return of minus 0.2%! If Morningstar and other commentators are right, investors would rather stick their money in a zero-interest bank account than try this investment.
Maybe most investors really are this conservative, but I’m not. I make sure that I have adequate cash reserves, and have safe investments for any money I will need in the next three years. After that everything is invested for the long term, and my risk tolerance is consistent with MRAR(0).