3 investment strategies to build a low risk portfolio

How to create a low risk investment portfolio to resist market volatility, reduce financial risks and valuation errors: three basic investment strategies to combine with each other according to the results you want to achieve. I immediately specify that this article is aimed at the most experienced and skilled investors because I report three low-risk investment strategies that require time, perseverance and some specific knowledge.

low risk investment portfolio

Investing in risky assets is not for everyone because in certain moments it is a risky choice that requires a great experience, and in any case it is not said that it can be a winning choice.

It does not mean that investing in risky assets is not recommended in general, on the contrary: in the long term we can reasonably expect that the performance is related to exposure to risk (high risk corresponds to high performance). And investing with a long-term time horizon, in principle, is recommended. But in the short-medium term, the correlation does not work so well because of market volatility: empirical evidence proves it. Much can be lost and the average investor probably cannot afford it.

Betting on a high expected return portfolio could easily lead to poor performance – it’s a matter of probability.

Volatility is a great risk factor for investment portfolios

An interesting solution could be that of investment portfolios structured to minimize financial risks, the so-called low risk investment portfolios. I try to give a concrete example.

In important studies and articles (e.g. M. Baker, B. Bradley, J. Wurgler “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly”, Financial Analysts Journal, Volume 67, 2011, and DC Blitz, P. Van Vliet “The Volatility Effect “, The Journal of Portfolio Management Fall 2007) it is shown that:

  • the error of the estimated “asset allocations” is significant
  • the portfolios with the highest expected return and the highest risk show high levels of error
  • low risk portfolios (to the left of the light blue line in the graph below) have low error levels
low risk investment portfolio returns
1000 portfolios were studied, and the optimal asset allocation for each level of risk (the “efficient frontier”) was estimated for each one. All 1,000 asset allocations were then placed on a risk / return graph, together with the real one (by definition, the blue line).

Other calculations show that with a investment portfolio in US shares with minimal volatility, invested for 30 years, a dollar would have become $ 59.55, while with an investment portfolio in US shares with maximum volatility, in 30 years a dollar would have become $ 0.59!

3 low risk investment strategies to combine with each other

Having ascertained that low risk portfolios are structurally a good idea, here are the basics of investment strategies to structure them. The three methods also work well on their own, but do not work miracles: they are “basic preparations” to be combined with each other according to the result you want to achieve.

Portfolio separation investment strategy

  • the overall portfolio is divided into two (or more) sub-portfolios, with very different levels of risk
  • the relative weight between the two sub-portfolios is periodically adjusted according to a signal, for example a systemic risk index (generated by an Early Warning) that promptly signals risk on / off phases
  • it rebalances itself “by event”, when the switch signal occurs

Rank-based portfolios investment strategy

It is one of the strategies preferred by many systematic professional managers and has a rather simple operation:

  • investment assets are sorted by a metric (eg, volatility, expected shortfall, downside volatility)
  • assets with lower risk are preferred, discarding others
  • the proportion is fixed or inversely proportional to the risk and can be conveniently divided between sectors and countries to avoid harmful concentrations of risk on certain factors
  • periodically (monthly, or even quarterly) it rebalances itself

Optimization-based portfolios investment strategy

This strategy derives from the Modern Portfolio Theory:

  • the portfolio is optimized (explicitly, using quadratic, linear or non-linear mathematical programming algorithms) starting from individual investments
  • in optimizing you can choose from a wide variety of objective functions, for example minimizing downside volatility, seeking equality of risk contributions (risk parity), minimizing volatility and so on
  • it rebalances periodically, usually on a monthly basis

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DISCLAIMER - Finance Drops is a blog that deals with topics related to personal finance, economic growth and savings management. It does not offer financial advice, the analyzes reported are to be considered general contents for information purposes. Finance Drops articles that talk about money cannot guarantee certain results because the possibilities vary according to the ability and economic situation of the reader. Finance Drops, therefore, cannot guarantee the success of the suggested strategies and does not assume responsibility for imprudent choices made on the basis of an incorrect perception of the contents of these pages. Risk Warning: Past performance reported in the articles cannot guarantee future results. Furthermore, products that allow access to leveraged instruments may involve a high degree of risk of loss of capital. All the solutions mentioned offer truly effective protective measures to manage risk, but sometimes it is possible to lose more than you invested.