3 investment strategies to build a low risk 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

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