There is a tendency for higher investing returns to come with higher risks. The difference in expected return between safe and risky investments is called the risk premium. It’s obvious that once you choose a risk level, you should go for the highest returns possible. The challenge is to choose an appropriate risk level.
One barrier to understanding risk is the way it is usually expressed. Saying that the S&P 500 has a 20% standard deviation means little to most people. In his book, The Intelligent Portfolio, Christopher L. Jones offers a good solution to this problem. Jones first assigns a risk level of 1.0 to the market portfolio, which is an average portfolio consisting of all asset classes in the proportions that exist in the marketplace. All other portfolios then have their risk level expressed relative to the market portfolio’s risk.
So, an all cash portfolio has a risk level of about 0.2, and a single large-cap stock has a risk level of about 3.0. This seems like a much more intuitive way to express risk than talking about standard deviations.
Armed with this metric, Jones works out several optimal portfolios at different risk levels. By “optimal” I mean that the portfolios have the highest possible expected return (based on a number of assumptions) without exceeding the chosen risk level.
Each of the optimal portfolios has a mix of cash, bonds, large-cap stocks, international stocks, and small- and mid-cap stocks. Jones analyzes three of these portfolios in detail:
Risk level 0.4: Safe portfolio (90% cash and bonds, 10% stocks)
Risk level 1.0: Market portfolio
Risk level 1.4: All stock portfolio
For each of these portfolios, Jones uses Monte Carlo analysis to compute the range of possible real returns. By “real returns” I mean the returns after subtracting out inflation. Here are the 30-year median returns:
Safe portfolio: 119%
Market portfolio: 326%
All stock portfolio: 444%
For money that I don’t expect to need for 30 years, the all stock portfolio looks like a significant improvement over the market portfolio. It certainly makes sense to look at the range of possible outcomes for each portfolio, but for me the added return outweighs the added risk.