Beyond risk tolerance

While investment professionals will likely agree that portfolios must be tailored to the circumstances of the investor, for many, the starting point is deciding where that investor stands on the spectrum of risk tolerance. An aggressive investor would be one willing to bear a high level of risk in pursuit of high rewards, while at the other extreme, a highly risk-averse investor would prioritize maintaining the value of their investments. Placing oneself on this spectrum of risk tolerance dictates the asset mix of the portfolio. Typically, the more aggressive the investor would be steered toward a larger share of stocks in the portfolio, while the more risk-averse would favor assets with considerably less price volatility.

I come to the task of designing a portfolio from a different starting point. I start with the determination of the investment horizon, rather than risk tolerance. Keeping it simple, I’m limiting my attention to three basic categories that I think should comprise the lion’s share of anyone’s savings. Those categories are (1) short-term interest-bearing instruments, (2) longer-term interest-bearing instruments, and (3) equities (stocks).

This first category consists of liquid assets that allow timely access to cash if needed. The foundation in this category should be money market deposits, which are simply checking deposits that pay interest. After that, I favor bank certificates of deposit (CDs) for this purpose. With most CDs, you’ll know exactly what you’ll earn over the course of the investment for any given maturity, and these investments are covered by FDIC insurance. CDs also have the feature that they effectively guarantee that you won’t experience a loss of principal. The only problem is that they require ongoing attention as you’d need to make ongoing choices for new CDs as seasoned CDs reach maturity.

We all have different sensibilities about the relative size of this category of assets held for liquidity purposes, but my approach would have you decide upon some upper limit for your money market funds or CDs. After satisfying that limit, excess funds would be allocated between stocks and bonds (or, equivalently, equities and interest-bearing or fixed-income securities). The portion allocated to stocks should increase as investment horizons lengthen. That is, the longer the investment horizon, the higher the proportion of funds allocated to stocks, and vice versa. Being entirely in stocks if your investment horizon is long enough – say for funds dedicated to retirement for a young worker with decades to go until retirement age – shouldn’t be considered aggressive — it’s rational.

The reason for this guidance is that stocks have tended to outperform other major asset classes over long time horizons. For shorter horizons where the expectation of stocks consistently outperforming is more tenuous (say less than 7-10 years), such a concentration in equities would, in my opinion, be ill-advised. While you can reasonably expect stocks to generate superior returns over other asset classes in the long run, depending on when you might choose to (or have to) liquidate your investment(s), the expectation of higher returns with equities may or may not be realized.

Bonds or other fixed income assets also exhibit volatility, but to a lesser extent. Thus, the addition of bonds to a stock portfolio tends to moderate the extremes of performance for the portfolio as a whole – both at the high end and the low end. Accordingly, holding some portion of a portfolio in interest-bearing securities would generally be expected to reduce that risk.

An element of conventional wisdom is that portfolios should be diversified within asset classes. Considering allocations to the equity portion of a portfolio, if you happen to pick especially high-performing individual stocks, you’re likely to significantly outperform the broader (i.e., more diversified) stock market, but doing so is difficult, as reflected by the fact that most professional stock pickers fail to beat the performance of the S&P 500 index consistently over time. Accepting this fact puts a pin in the notion that you’re likely to outperform by picking individual stocks rather than holding a broad portfolio of stocks or the idea that you can improve your performance by timing when to get in and out of the market.

For that reason, my own preferred vehicle for owning equities is the SPDR (SPY) – an exchange traded fund that trades just like a stock and gives exposure to the S&P 500 cheaply and efficiently. The idea is that your investment horizon for these stocks should be long enough so that you have a high probability that any bearish periods that may arise will likely be of relatively short duration such that the expected superior returns are still realized.

The same concern about diversification applies to the fixed-income portion of a portfolio, although in this case the choice of which asset to buy is less obvious. For one thing, the financial landscape of interest-bearing instruments is littered with products of different designs and characteristics; but more than likely, some kind of bond fund would serve as the foundation of this portion of the portfolio. I urge a bond fund, rather than a selection of individual bonds for the same reason I prefer a broad stock index fund over individual stocks. Choosing a bond fund, however, is fraught.

Generally – but not always -- credit markets are such that bond buyers will find higher yields associated with longer maturity instruments, which would likely tempt investors to buy the bonds with the longest maturities. This choice, however, is not without its risks. Traditional bonds are usually issued at par (e.g., $1,000), pay interest periodically, and then return the par amount to the investor upon maturity. The yield to maturity will be known at the inception of the investment, but realizing that yield requires that the interest payments received during the life of the bond be reinvested at that same yield-to-maturity interest rate – something that’s not going to happen.

Perhaps more concerning is the fact that all bets are off if the bond is liquidated before it matures. Because bonds trading in the secondary market must compete with new issues, if market interest rates rise, the price of a seasoned bond will have to fall to be competitive with the newer alternative. Similarly, if interest rates fall, prices of seasoned bonds will rise. Put another way, bond prices and interest rates move inversely. Critically, returns can fluctuate meaningfully from year to year and may differ from initial yield expectations.

Moreover, discerning skill from luck is next to impossible. Actively managed funds, as most of these bond funds are, require ongoing rebalancing of bond holdings to satisfy the criteria dictated by the fund’s prospectus. For instance, a medium-term bond fund manager would have to replace shorter maturity bonds with longer maturity bonds as the former approach the minimum maturity requirements of the fund. The timing of such adjustments, however, involves considerable discretion, making it hard to compare competing funds.

As mentioned above, the length of the investment horizon should drive the percentage of allocations between stocks and fixed income assets. With stocks, it’s easy to find passive investments like the SPY that you can park your funds in and largely ignore, assuming the long-term investment horizon applies. For bonds, it’s a bit chancier, as we don’t have an instrument analogous to the SPY that we can reasonably expect to be top-performing. The market does offer a variety of funds that strive to mimic established benchmark indices, but because these funds are dynamically managed, they can’t be expected to align neatly with a specific investment horizon. I therefore favor actively traded funds that maintain exposure across a broad range of maturities. This approach, while imperfect, helps balance flexibility with stability over time.