Investing in recent years has seen a trend of a small number of highly outperforming stocks carrying the larger portion of growth in the market. This has led retail investors to be more interested in chasing these gains in the hope of capturing this growth in lieu of what might be a more appropriate portfolio for their needs. At JGUA, we see the value in a more balanced portfolio, in what you might know as a “risk-adjusted portfolio”.
But what exactly does that mean, and why should you care about creating one?
At its core, a risk-adjusted portfolio is an investment strategy that seeks to balance risk and return in a way that maximizes the potential for growth while minimizing the likelihood of significant losses. Simply put, it’s a portfolio that takes into account how much risk you’re willing to take on and strives to optimize your returns in relation to that risk.
Every investor faces a basic choice: How much risk are you willing to take for the chance to make a higher return?
- High-risk investments (like individual stocks or high-growth sectors) can offer potentially high returns, but they also come with the risk of significant loss if the market takes a downturn.
- Low-risk investments (like bonds or index funds) are generally safer but offer more modest returns.
To construct a risk-adjusted portfolio, you must first determine a few key factors:
- Your Risk Tolerance: Are you someone who can sleep soundly through market volatility, or do you prefer a more stable investment approach? Your tolerance for risk will help dictate the kinds of assets you should consider. This can largely be affected by your age and when you will need to withdraw your assets.
- Asset Allocation: This is the process of deciding how to distribute your investments across different types of assets such as stocks, bonds, and alternative investments like real estate or commodities.
- Diversification: Diversifying your investments across different sectors, industries, and geographical locations reduces the risk of your entire portfolio taking a hit if one area of the market underperforms.
- Risk Metrics: Investors often use metrics like the Sharpe ratioor Alpha to assess risk-adjusted performance. These measures help to quantify the risk you’re taking and evaluate whether your returns are worth it in the context of that risk.
Why Would You Want a Risk-Adjusted Portfolio?
A risk-adjusted portfolio can provide needed stability throughout market cycles, allowing you to weather downturns, while also aiming to create consistent growth over a long period of time.
- Balancing Risk and Reward: The primary benefit of a risk-adjusted portfolio is that it helps you achieve a balance between risk and return. By considering the level of risk you’re comfortable with and adjusting your investments accordingly, you can avoid the extremes of overly risky or overly conservative portfolios.
- Protection During Market Downturns: No one can predict market crashes, but a risk-adjusted portfolio can help protect you during periods of volatility. By spreading your investments across different asset classes (stocks, bonds, real estate, etc.), you can minimize the chance of your entire portfolio crumbling when one sector falters.
- Maximizing Returns for the Risk You’re Willing to Take: You don’t want to take on more risk than necessary to achieve your goals. A risk-adjusted portfolio helps you focus on maximizing returns while staying within your comfort zone. The goal is not just to get the highest return possible but to do so with an acceptable level of risk.
- Long-Term Growth: Building a risk-adjusted portfolio means you’re setting yourself up for consistent, long-term growth. Short-term market fluctuations will happen, but the focus on risk management ensures you can ride out the ups and downs while staying on track with your financial goals.
- Psychological Comfort: Knowing that your portfolio is constructed in a way that reflects your risk tolerance can also provide peace of mind. Investors who take on too much risk often experience emotional stress, leading to impulsive decisions during market downturns. A risk-adjusted approach allows you to stay invested with confidence, even when the market is unpredictable.
A risk-adjusted portfolio doesn’t completely avoid risk, it’s not about playing it safe all the time, but it ensures that the level of risk you’re taking is appropriate for your goals and financial situation. It’s about strategically choosing assets in a way that maximizes returns without exposing you to unnecessary risks. I implore you to take the time to review your invested assets and be sure that they are constructed in a way that reaches your goals while also being comfortable.
