Risk-Calibrated Portfolios

The stacked chart of Figure 11-1 shows the general asset class allocations for 20 of 100 different risk-calibrated Index Portfolios. The Index Portfolio number matches the equities (stocks) allocation of that portfolio; i.e. Index Portfolio 20 has a 20% equities allocation, and Index Portfolio 80 has an 80% equities allocation. In the chart, gold represents each portfolio's weighting in fixed income, and burgundy represents its percentage of equities. Almost all of the asset allocations carry the same asset class components — fixed income, U.S. stocks and non-U.S. stocks and REITs — but weighs each differently. For example, the least risky Index Portfolio displayed, number 5, is heavily weighted in fixed income, carrying very little global equity exposure. This portfolio is well suited to an investor with a very low risk capacity — in general, someone with a short investment time horizon and current liquidity needs. An example of this type of investor would be an older retiree. To really simplify the matching of people and portfolios, investors could match their age to the allocation of bonds in an index portfolio.

Figure 11-1

The highest risk capacity Index Portfolio 100 may be suitable for either a very young investor just starting out or someone who fluently speaks riskese, and will not need to liquidate his investments for a minimum of 15 years, has a high net worth and net income, and a strong stomach for volatility.

The higher risk Index Portfolios 75 and 100 have a high stock market exposure and a considerable tilt toward small and value indexes. The increased volatility of these higher risk index portfolios had higher returns over the 35-year period from January 1, 1979 to December 31, 2013, relative to the less volatile Index Portfolios 25 and 50. As Figure 11-2 shows, an individual who invested $1 in a lower risk Index Portfolio 25 would have grown his investment to $14.00 in the 35-year period. However that same dollar invested in a higher risk Index Portfolio 100 would have grown to $83. This example provides evidence for the importance of establishing the efficient asset allocation that is best matched to an investor's risk capacity.

Figure 11-2

Step 11PortfolioRisk-CalibratedAsset ClassAllocationsRisk Capacity