Target Risk Strategy is
designed to focus on volatility to stay closer to an investors’ true risk
tolerance.
Risk allocation has calmed investors’ nerves by delivering a
gentler ride while still producing stock-like returns over the long haul. In
the traditional asset-allocation model, investors devote a set portion of their
portfolios to various asset classes – such as 60% to stocks and 40% to bonds –
based on their expected returns. The idea is to temper the risk of stocks with
safer bonds and other asset classes.
The problem? In a market
storm, asset classes can plummet more than investors expect, and often in
unison. That happened in 2008 when stocks, commodities and investment – grade
corporate bonds all plunged. In contrast, risk-based portfolios focus on
volatility, not expected returns. Such portfolios change their holdings based
on each asset class’ volatility at any given time.
For example, some analyses have shown that emerging- market
bonds perform much more like stocks than like U.S. Treasury bonds over the long
run. Yet a traditional asset allocation might lump emerging-market bonds with
Treasury’s and other, much safer bonds. A risk-allocation approach would place
emerging-market bonds with stocks and other more volatile assets, offering
a truer picture of risk.
When done properly risk allocation produces a portfolio that is
both safer and closer to investor’s true risk tolerance, helping them sleep at
night – and allowing them to stay fully invested even in market storms.
WHY
VOLATILITY MATTERS
On Wall Street, volatility is defined as the variation of an
asset’s returns from its average. The average volatility of the Standard &
Poor’s 500-stock index has been about 16% during the past 60 years. In
math-speak, that means there was 68% (or “one-standard-deviation”) chance that
the annual price change in any given year was 16 percentage points above or
below the average.
During the past four years, the index’s volatility has been
about 28% -- meaning a 28 percentage point lurch in either direction from the
average.
Higher volatility can cause investors to panic, even when the
market is rising. In 1991 and 2009, for example, the S&P 500 rose 30% and
26% respectively. But volatility was just 14% in 1991, versus 27% in 2009. The
upshot: Investors in 2009 had many more chances to panic and pull out. If they
did, they missed out on further gains. The trick is to figure out how to use
volatility data to your advantage.
RISK
BUDGETING
The traditional portfolio for safety-minded investors who want
decent returns is 60% stocks and 40% bonds. Such a portfolio, made up of the
S&P 500 and the Barclays Aggregate Bond index, has historically returned
about 10% annually, including price appreciation, dividends and interest
payments, according to data from researcher Morningstar. But in 2008, the
portfolio had losses of 21%. Investors also have more assets to choose from
nowadays that don’t fit neatly categories like “stocks” and “bonds.” Those
assets can range from emerging-market stocks and bonds to real-estate
investment trusts.
Risk budgeting tries to address the shortcomings of traditional
asset allocation portfolios. Instead of picking a static stock-bond allocation,
investors decide how much volatility they are willing to take. Then, they
allocate their portfolios to stocks, bonds and other asset classes with the
idea of spreading out the sources of volatility. Such an analysis shows a key
problem with the 60/40 portfolio: Even though only 60% of the money goes to
stocks, about nine-tenths of the overall portfolio’s volatility comes from
stocks and only 10% from bonds. That means the investor isn’t nearly as
diversified as intended.