Risk vs Reward and Portfolio Construction

Risk vs Reward and Portfolio Construction

The one thing you must be comfortable with when investing is dealing with risk. Investing requires managing risk to maximize potential reward. Maybe you have heard the quote: “No risk, no reward.” Let us explore the topic of risk vs reward and see how we, as an investor, can manage our risk while trying to maximize our potential return.

Risk vs Reward by Asset Classes

If you have started investing, you should know the various asset classes you can invest in. Each of these asset classes has different risk profiles. If you sign up with a broker / financial adviser, you may have been asked to fill in your risk tolerance profile. This risk profile allows your financial adviser to asses what asset classes may suit you.

Risk vs Reward Chart
The relationship between Risk vs Reward for various asset classes

In short, the lower the risk, the lower the volatility and the potential reward. The higher the risk, the higher the volatility and the potential reward (and losses).

For the lowest risk, you can invest in government securities such as SSB, SGS, T-Bills, or fixed deposits which guarantee your initial principal and a fixed rate of return. We call these instruments “as risk-free as you can get.”

Conversely, investing in small-cap stocks can be considered one of the riskiest investments because you may completely lose your initial principal. Your potential return is also higher if these small-cap companies grow to become one of the largest companies in their industry. Going further in the risk spectrum, venture investment in startups has an even higher risk profile. Tough, the return could be spectacular should the startups go public.

There are no right or wrong choices because the preferred asset classes will differ for different investors based on their risk profiles and investment horizon.

As an investor, you should be aware of the relationship between this risk vs reward so that you can optimize your investment portfolio according to your risk tolerance and the rate of return you want to aim for.


Portfolio Construction for Optimizing Risk vs Reward

As you start your investing journey, you must be aware of the risk tolerance you are comfortable with so that you can do a well-balanced portfolio construction optimizing for this risk vs reward tradeoff.

Another essential thing to consider is your investment horizon. We always advocate the mindset of long-term investing. Why is that? Because over the long term, the market tends to go up. However, if your investment horizon is shorter, or maybe you have retired, your risk profile should be much lower than those who are younger. Remember, higher risk means more volatility, which means your portfolio may swing wildly in the short term. And it may take a relatively long time to recover, which, if you are already in retirement, is something you probably do not want to deal with.

Most investors invest in several asset classes to achieve a better risk vs reward tradeoff. This is called diversification. You can have some percentage devoted to asset classes with higher potential returns while the rest with a more stable return to insulate your portfolio from market volatility.

As investors age, their portfolio’s share of risky assets should decrease. You can enjoy your retirement better with less volatility and more guaranteed return.

Let’s look at several portfolio compositions that may suit various investors of different risk profiles.

Conservative Portfolio

The main goal of a conservative portfolio is to preserve capital. This can be achieved by investing a large portion of the portfolio into the lowest-risk asset classes, such as government securities or fixed deposits. As much as you want to avoid risky assets, investing a small portion of your portfolio in higher-yielding asset classes such as blue chip large-cap stocks is usually still helpful. This composition allows you to have a stable return on your portfolio from the fixed-income investments while enjoying some growth from the riskier equities.

Risk vs Reward: Conservative Portfolio
Conservative portfolio: Majority in fixed income and a small portion in equities

Another typical conservative portfolio is investing most of your portfolio into physical real estate. Real estate tends to have lower volatility while still providing a great rate of return. The downside of owning physical real estate is managing and maintaining them, especially if you rent them out. If you are comfortable with real estate management, this is one of the common routes investors take to build wealth. As with the diversification principle, you can invest in other riskier assets, such as equities, to round up your portfolio.

Conservative portfolio with real estate
Conservative portfolio with real estate

Balanced Portfolio

A balanced portfolio seeks to achieve both growth and income. This can be achieved by dividing the portfolio into fixed income and equities equally. This portfolio has a higher risk level than a conservative portfolio; thus, this is only recommended to investors with a higher risk tolerance and longer investment horizon.

Risk vs Reward: Balanced Portfolio
Balanced portfolio: Half in fixed income and half in equities

Aggressive Portfolio

The goal of an aggressive portfolio is to achieve long-term capital growth. This is the highest spectrum in risk vs reward. To achieve capital growth, the portfolio will consist mainly of equities. Depending on the investors’ risk tolerance level, some may even favor smaller caps stocks to boost the potential return. Because a big chunk of this portfolio consists of equities, the volatility of this portfolio may be wild in the short term; therefore, this portfolio is only recommended to investors with the highest risk tolerance and longer investment horizon.

Risk vs Reward: Aggressive portfolio
Aggressive portfolio: Majority in equities and a small portion in fixed income

Portfolio Rebalancing

After you have completed your portfolio construction and achieved the desired allocation percentage, your job is not done. Remember that each asset class has a different expected rate of return; therefore, over time, your portfolio allocation may change as some assets grow faster than the rest. If you still prefer the same portfolio allocation, you need to rebalance your portfolio by selling the one with extra allocation into the one with lower allocation.

You should also continuously asses your investment objective and see if your current portfolio still suits you. If your investment objective changes, you should adapt your portfolio accordingly. For example, if you decide to retire earlier than expected, you may want to adjust the risk level of your portfolio as well.

Which is right for you?

You know best your risk tolerance level and how long your investment horizon is. You can adopt one of the portfolio compositions above and adjust it to suit your investment preference. For example, if you want a balanced portfolio but still favor more growth, you can change the portfolio composition to 60% equities and 40% fixed income. When you work on your portfolio construction, remember the relationship between risk vs reward so you can optimize your portfolio well.


Case Study of Stock and Bond Portfolio

One of the most common portfolio compositions is a mix of bonds and stocks. We can see how different compositions impacted investment return based on the last 90 years of investing data between 1926 to 2019. The following chart portrays the relationship between risk vs reward.

Stock Bond Allocation: Average, best, worst annual returns
The diagram shows the average, best, and worst annual returns for various stocks and bonds allocations. Credit to VisualCapitalist.[1]

The most conservative portfolio has the lowest average annual rate of return (5.3%). However, it also has the least drawdown (-8.1%). On the opposite end, the most aggressive portfolio has the highest average annual rate of return (10.3%) but with the wildest pullback (-43.1% drawdown). Before adopting the more aggressive portfolio, ensure you are comfortable with the volatility. Happy investing!

Stock | Bond Allocation Average Annual Return Best Annual Return Worst Annual Return
0% | 100% 5.3% 32.6% -8.1%
10% | 90% 6.0% 31.2% -8.2%
20% | 80% 6.6% 29.8% -10.1%
30% | 70% 7.2% 28.4% -14.2%
40% | 60% 7.8% 27.9% -18.4%
50% | 50% 8.3% 32.3% -22.5%
60% | 40% 8.8% 36.7% -26.6%
70% | 30% 9.2% 41.1% -30.7%
80% | 20% 9.6% 45.4% -34.9%
90% | 10% 10.0% 49.8% -39.0%
100% | 0% 10.3% 54.2% -43.1%

[1] Stocks represented by the Standard & Poor’s 90 Index from 1926 to 3 March 1957; the S&P 500 index from 4 March 1957 through 1974; the Wilshire 5000 index from 1975 through 22 April 2005; and the MSCI US Broad Market Index until 2019. Bonds are presented by the S&P High Grade Corporate Index from 1926 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Bloomberg Barclays U.S. Long Credit AA Index from 1973 through 1975; and the Bloomberg Barclays U.S. Aggregate Bond Index until 2019.

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Disclaimer: The information provided here is not intended to be and does not constitute financial advice, investment advice, trading advice, or any other advice or recommendation of any sort.

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David Ang

About David Ang

A long-term investor with a portfolio across the United States and Asian equities, REITs, commodities, and fixed incomes. After over a decade of hands-on investing (and making countless mistakes), I'm excited to use this platform to share what I've learned over the years. And let's continue to learn together. Writing about macro economy, equities, personal finance, web3. Follow me on Twitter: @danggaku