A new white paper from Ampersand Portfolio Solutions, entitled The Risk Contribution of Stocks, puts a spotlight on the risk contribution of stocks in a portfolio and urges investors to diversify into other asset classes.
The paper states that most investors, both individual and institutional, believe that stocks are a good, perhaps even the best, investment in the long run.
However, the reason for expecting good performance from stocks is not always fully understood: Quite simply, it is because they are risky, the firm says.
The paper illustrates the riskiness of stocks; a value that escalates when volatility increases.
“While most investors believe that a 60/40 stock/bond portfolio is well diversified, they are mistaken. Ampersand analyzed the volatility of stocks and bonds over a 41-year period (1975-2016). They constructed a 60/40 stock/bond portfolio and found that the risk contribution of stocks is a whopping 92 per cent. An 80/20 stock/bond portfolio is even riskier, with stocks accounting for 98 per cent of the risk. In a 40/60 stock/bond portfolio, 76 per cent of the risk still comes from stocks, and even a portfolio with as little as 20 per cent allocated to stocks derives almost 40 per cent of its risk from stocks. Nonetheless investors continue to hold significant positions in stocks because of the expected higher returns.”
To examine how diversification beyond bonds and into other non-correlated investments affect the risk and returns of a portfolio, Ampersand added another asset class, managed futures, to the stock/bond mix to examine the diversification benefits.
Examining the total risk of various hypothetical stock/bond/managed futures portfolios reveals that the portfolio with the lowest risk is 80/20 bonds/managed futures (zero stocks). However, this portfolio also has the lowest expected return. Creating an optimal portfolio requires a closer look at Sharpe Ratios, the measure of how much ‘risk premium’ a portfolio earns per unit of risk it takes. All else equal, a higher Sharpe Ratio implies a more desirable portfolio, the paper finds.
Analysing the Sharpe Ratios for various portfolios, the portfolio with the highest Sharpe Ratio (0.95) turns out to be a 20/50/30 stock/bond/managed futures portfolio. This portfolio showed the highest reward-to-risk ratio and could be considered the optimal allocation strategy, the firm says.
A closer look reveals that in this 20/50/30 stock/bond/managed futures portfolio, all three asset classes contribute almost equally to the risk of the portfolio – sometimes referred to as a risk parity portfolio.
“According to Modern Portfolio Theory, the portfolio with the highest Sharpe ratio, where risk contributions are spread out across the component assets classes, is also called a ‘tangency portfolio’ and is considered the optimal portfolio for all investors.
“Each investor can combine this ‘tangency portfolio’ with risk-free lending or borrowing which provides an appropriate, customized level of risk while maintaining a high Sharpe Ratio. For example, risk-averse investors can combine the “tangency portfolio” with risk-free lending to dilute their risk. This risk averse investor can invest 50 per cent in the ‘tangency portfolio’ and the other 50 per cent in T-Bills, thereby reducing the risk while maintaining good performance. For risk-tolerant investors, they can borrow at the risk-free rate and leverage the portfolio which boosts both the risk and the returns. These tangency portfolio strategies are constrained, however, because all allocations, even when borrowing or lending, sum up to 100 per cent.
“What happens if the constraint is relaxed and the allocations go beyond 100 per cent? This idea is called ‘extended diversification’ and is very powerful.
“‘Extended diversification’ allows investors to potentially harness the combined benefit of their current portfolio and add an allocation to managed futures. Traditionally this has been an either/ OR decision which involves selling part of an existing stock or bond portfolio and adding exposure to a diversifying asset class such as managed futures in place of the stocks and bonds. The portion allocated to the diversifier (managed futures) forces an investor to choose between stocks and bonds OR managed futures. In the end, however, this OR decision may result in giving up the returns that the relinquished stocks and bonds might have continued to earn.”