Managing Risk | Part 4: Putting It All Together

Author: Nathan Rowader
Date: October 2, 2014
Category: Financial Planning
Tags: , , , , ,

In the past few weeks we have discussed the complicated nature of averages, explored a simple method for forecasting returns and discovered how volatility-based rebalancing has the potential to deliver some great returns for investors. This week, we are going to put it all together using each element of the portfolio construction process.

As you might recall, building a well-constructed portfolio relies on three inputs:

  • Return
  • Volatility
  • Correlation

In Part 2 of the managing risk series, I outlined a way for an investor to forecast returns using growth domestic product (GDP) expectations to estimate earnings and dividend growth. For this week’s illustration, I calculated forecasted return using the method outlined in Part 2 for a hypothetical example allocating between stocks and bonds for the past 10 years. As part of this illustration, I used the year-end yield of the Barclays U.S. Government/Credit Bond Index (bonds) as a forecasted return for bonds for each calendar year.

Next, I used a six-month moving average of volatility for stocks and bonds and a fixed historical correlation. This was the method I used in the volatility rebalancing discussion in Part 3 of the managing risk series.

Finally, I rebalanced a portfolio of stocks and bonds to deliver the maximum return given a target level of 10% volatility (a level similar to a 50% stock/50% bond portfolio). As you can see, the combination of reasonable expected returns and a volatility target that keeps a portfolio properly invested in every market type delivers the best results with the lowest level of risk.


Just like the example I provided in Part 3, the hypothetical portfolio allows for shorting and leverage. This is typically unusual for most investors, but it is hard to argue with the results. At one point in the results the portfolio went as high as 137% in stocks and as low as -66%.

I hope that this series has given you some food for thought!

See the rest of the series: Part 1 | Part 2 | Part 3

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