How Risky Is Your Portfolio? May 2021

Crater Lake, OR. Wide angle image made last week.

Portfolio risk is a subject I’ve written about in prior blog posts.  It is particularly important now that U.S. Equities are hovering around all time highs and we are entering the summer months when the stock market tends to generate less than stellar returns.  Remember the slogan, “Sell in May and go away?”  The “go away” applies until after Halloween.  While I don’t intend to sell all holdings and move to cash, it is prudent to be aware of how risky your portfolio is in this high volatile market.  Let’s take a look and roughly pin down the risk for a basic 60% stocks/40% bond portfolio.

If you missed this post, review if interested in controlling portfolio risk.

This not for the mathematically squeamish, but the concept is not difficult if one can get past one step in the logic.  Let me explain the Risk Parity calculation by first beginning with a reference to a paper (Risk Parity Allocation by Edward Qian) that brought this idea to my attention.

A standard portfolio breakdown between stocks and bonds is 60%/40%.  Most investors will argue this is a well-diversified and somewhat conservative portfolio.  It is certainly more conservative than most of the ITA Wealth Management portfolios are at this time as the Kipling Buy-Sell-Hold model is recommending a major tilt toward equities.  In other words, most of the ITA portfolios carry a very high risk, assuming one is not using any type of sell limit orders.

Is the 60/40 mix a conservative portfolio?  I just checked my data sources and found that the standard deviation (SD) of stocks over the past five years is +/-18.5% and the SD for bonds is +/-3.15%.  For ease of calculation I’ll round those figures to 18% for stocks and 3% for bonds.  However, when one takes variance into account, we must square each number so the 18% has a variance of 324 and for bonds it is 3 x 3 or 9.  In terms of variance, stocks are 36 (324/9 = 36) times riskier than bonds.  That is a huge difference and significantly higher than it was just a few years ago.  Even if stocks carried a standard deviation of 15% and bonds 5%, in terms of variance, stocks are nine times riskier than bonds.

To borrow the analogy from Edward Qian, if we go back to the 60/40 stock to bond split, we have six stock eggs and four bond eggs.  To calculate the true risk to stocks we find we have 220 (36 x 6 + 4) eggs in total.  Two hundred and sixteen (216) out of 220 are tied to stocks or approximately 98%.  Very close to 100% of the 60/40 portfolio of risk is carried by the stock portion of the portfolio.

With stocks running at +/- 18% per year we are investing in a volatile market and that is why I strongly suggest setting Trailing Stop Loss Orders (TSLOs) if one is interested in preserving capital.  This is less important for young investors as you have more time to recoup losses.

Just for fun, how risky is a 30%/70% stock/bond division in today’s volatile market?

Now we have 3 stock eggs and 7 bond eggs.  Calculating for variance we have 9 and 49 as both need to be squared.  Running similar calculations we have the following.

(36 x 3 + 7) = 115.  Therefore, 115 – 7 = 108 out of 115 or 94% of the portfolio risk is tied to stocks.

Some investors pay no attention to portfolio risk.  An argument may go like this.  I have sufficient investments such that the dividends pay my living expenses and I could care less about the price volatility of individual securities.

If market volatility is of concern, I highly encourage investors learn how to calculate Jensen’s Alpha and work that into your portfolio management toolbox.

If you spot any errors in the logic or calculations, please leave a comment so I can make corrections.