Why a 60:40 portfolio isn't ideal

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Empirical research shows that 60/40 portfolio has a high correlation with the broad stock market index. This means that the portfolio will go down significantly if the broad market were to decline.

It is important to note that the exposure to equity exposes the portfolio to high beta risk; beta is a measure that shows how much the portfolio moves for one point move in the benchmark index. Besides, a significant proportion of the volatility from a 60/40 portfolio is contributed by equity.

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The higher volatility could lead to higher downside risk. And that translates into higher risk exposure to equity - sometimes higher than its 60 per cent contribution to the total asset value in the 60/40 portfolio.

One suggestion is that investors can construct portfolios based on their risk tolerance levels, which define their risk budgets.

Post-modern portfolio theory

Modern portfolio theory shows that the total risk, captured by the standard deviation (SD), is reduced when two or more assets with correlations less than one are combined to form a portfolio.

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The argument is intuitive. The investment risk is very high if an investor has exposure to just one stock. If the investor, however, has exposure to two stocks, the chances of both stocks going down by the same percentage at the same time is less.

The problem, however, is that portfolio theory defines risk in terms of SD. And SD measures the upside and downside movement in asset prices. Investors desire upside movement; it is the downside movement that is unnerving.

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More precisely, investors are concerned about their portfolio returns slipping below a minimum acceptable return. This is the return required to meet the desired investment objectives. This is the basis of post-modern Portfolio Theory on which we build the risk-allocation-based portfolio.

Risk allocation portfolios

The objective of a risk-allocation-based portfolio is to reduce the portfolio's downside risk. The process is similar to computing standard deviation.

The investor has to first define the minimum acceptable return and take the annual returns below this level to calculate downside volatility. The purpose is two-fold. One, to the find the number of times the asset class has declined below the number. And two, to find the magnitude of the decline below the minimum return. All returns above the minimum level are, hence, treated as same and reset to zero.

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The downside volatility is calculated for a broad asset class such as the S&P CNX 500 or for a style benchmark such as the CNX Mid-cap Index. The objective is to custom-tailor the exposure to the equity asset class based on the downside volatility and the investor's risk tolerance level. A similar process can be done after the security selection process to check if the portfolio, if so constructed, falls within the risk budget.

Conclusion

Investors may have to eventually fine-tune the allocation to enable the portfolio meet the desired investment objectives. But a portfolio constructed off the risk budget would be more meaningful than a rule-of-thumb 60/40 portfolio. Investors can follow the same process to construct portfolios containing more than two asset classes (stocks, bonds and commodities, for instance).