Risk-Weighted Portfolios

Many investors are surprised to learn that their 60% stock/40% bond portfolios derive the vast majority of their volatility from the stock market. To get a truer picture of what makes a portfolio tick, investors have to consider not only their dollar allocation but their risk allocation. Investors are rewarded for taking risks, but it usually makes sense not to put all their risk eggs in the same basket.

You can estimate your risk exposure by multiplying your dollars allocated to each asset class by its volatility (standard deviation) and by its correlation to the other assets in your portfolio. Here is a spreadsheet you can download to see how this works. The results are presented based on our calculations of the performance of each underlying asset classes from 1995-2010. Note: This information has been obtained or derived from sources believed to be reliable. However, we do not make any representation or warranty, express or implied, as to the information’s accuracy or completeness, nor do we recommend that the information serve as the basis of any investment decision. The spreadsheet has been made available to you solely for informational purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchase any securities or other financial instruments, and may not be construed as such.

A lesson from the Panic of 2008 is that investors are better off starting with the risks they can afford to take and then maximizing their returns from there, rather than trying to maximize their returns and only worry about the risks after it is too late.