This week I’ll shift away from the cognitive biases and irrational behavior that affect our decision-making, and instead shift my focus towards one of the most important aspects of investing: portfolio theory. Modern portfolio theory (MPT) focuses on building a portfolio of assets that maximizes the risk-adjusted return — that is, maximizes the expected return of an investment portfolio while minimizing its risk (learn more about how to avoid risk here). MPT uses concepts gleaned from finance and econometrics to build a diversified portfolio, and some of the mathematical models can be rather complex. But at a fundamental level, MPT concerns diversification, and the tradeoff between risk and reward. I may delve into the more esoteric aspects of MPT in the future, but for now, I will focus on this simple, yet significant tradeoff.
If we make the reasonable assumption that individuals are risk-averse — that is, all else equal, they would prefer less risk — then in order for an investor to accept more risk, they must have a higher expected return. While there are a variety of strategies to hedge risk, from option spreads to diversification, it is virtually impossible to completely eliminate all investment risk without resorting to a portfolio comprised entirely of “risk free assets,” usually U.S. Treasury bonds (if the United States ever actually defaults on its debt, the only resources of any value will be canned food, bottled water, and ammunition). But the goal should not be to avoid risk, but to understand its integral role in investment decisions.
Using the aforementioned rule, portfolios with greater risk should have a higher expected return; however, this return will naturally be more volatile. A higher expected return means a higher return on the average. In any given instance, it is likely to be extreme and produce either a large gain or loss. The opposite is true of lower risk portfolios — the average return will be lower, but it is more likely to be consistent, and its spread will be smaller.
That is not to say a riskier portfolio will necessarily always yield a higher return. Part of smart investing centers around making calculated risks by building portfolios where risk is correlated with expected return. MPT was born out of the desire to mathematically optimize risk-adjusted return, but it is not necessary in order to achieve correlated risk and return.
With a firm understanding of the relationship between risk and return, it is important for an investor, especially a beginner, to understand his or her “risk appetite,” otherwise known as one’s willingness to accept greater risk, in return for a higher expected return. “Risk appetites” are also heavily influenced by one’s “investment horizon” — how long one expects to hold an investment, whether an individual asset or an entire portfolio.
Most long-term investing is focused on increasing one’s assets for retirement. Since most new investors are relatively young, either in their college years or early twenties, they tend to have decades to go before retirement, giving them a rather distant investment horizon, and thus a naturally greater risk appetite. Young investors should generally accept more risk, whether that takes the form of more aggressive investments in newer companies, high-growth index funds, or leveraged ETFs. While greater risk leaves young investors open to losing more on a downward market swing, they have the time to bounce back.
The opposite is also true. Investors with smaller investment horizons — whether they’re older, and therefore closer to retirement, or have short-term goals, such as maximizing the value of college funds for their children — should have less of an appetite for risk. This often takes the form of a focus on blue chip stocks, steady index funds, and low-risk bonds.
The reasoning behind this is fairly straightforward. An investor in their twenties should be less concerned with the possibility of suffering a large loss in the short run (a couple of years) if they are able to achieve a much larger gain over the long term (a decade); once they reach retirement age, the short-term losses are far less important than the larger, long-term gains. On the other hand, an investor in their seventies should prefer a lower, albeit much more consistent, return; they are far less likely to have the time and resources, especially if they are no longer working, to be able to recover from short-term losses. In the end, it comes down to the short run versus the long run, and which is more important to your investment decisions.
There are, of course, many aspects of portfolio theory beyond risk appetites and investment horizons. But these are fundamental parts of investing, and they should be properly understood by all. Each and every investor should carefully consider (and regularly re-evaluate) their appetite for risk, and the level of risk in their portfolio, in order to meet their specific investment goals.