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The Optimal Investment Portfolio

Investors desire the smoothest path possible to their investment returns. The optimal investment portfolio maximizes your returns for the risk you take and should be the goal for every investor.

How do you define the “Optimal” Investment Portfolio?

Simply put, the “optimal” investment portfolio is the portfolio that provides the greatest return for the least amount of risk. All else equal, we want a more stable ride to our desired return.

Ideally, an investment would offer our desired return with no volatility or drawdowns. But the only investment that offers guaranteed returns is cash. If you want or need to earn more than cash, then you need to take some risk.

The Sharpe Ratio is an excellent metric to evaluate the risk-return characteristics of a portfolio. The Sharpe Ratio measures the “excess return” (the return above cash) of an investment portfolio per unit of risk (volatility).

The Sharpe Ratio equation is:

Sharpe Ratio equation

The Sharpe Ratio allows investors to compare portfolios with different risk levels and understand which portfolio is most efficient (greatest return per unit of risk).

The portfolio with the greatest Sharpe Ratio can be considered the “optimal” portfolio.

What makes for an “Optimal” portfolio?

The optimal, or highest Sharpe, portfolio tends to be a diversified mix of assets with balanced exposures across major economic environments.

Although more concentrated portfolios may outperform over shorter time horizons, over longer time horizons the greater diversification of a balanced portfolio tends to produce better risk-return metrics.

Consider the following comparison of a 100% global stock portfolio, a 60% stocks and 40% bonds portfolio, and a “Risk parity” style portfolio composed of 30% stocks, 55% bonds, and 15% gold from 1996 through 2023.

Investment performance comparison of stocks, 60/40 portfolio, and a risk parity style portfolio.

Performance of global stocks, 60% global stocks & 40% bonds, and a risk parity style portfolio composed of 30% global stocks, 55% bonds, and 15% gold from May 1996 through December 2023. Global stocks are composed of 60% U.S. Stocks (VTSMX) & 40% International Stocks (VGTSX). Bonds are proxied by Vanguard Interm-Term Treasury Inv (VFITX). Gold is proxied by the Gold Fixing Price in London Bullion Market 3:00 PM (London time) through 2004 and SPDR Gold Shares (GLD) from 2005 to present. All portfolios are rebalanced annually.

Comparing returns alone, the 100% stock portfolio comes out on top with an annualized return (CAGR) of 7.5% compared to 6.8% for stocks & bonds and 6.1% for risk parity. However, the stock portfolio achieves these returns with significantly more risk.

Risk can be measured in volatility (standard deviation) and maximum drawdown, among other statistics. The 100% stock portfolio achieved its returns with a standard deviation near 16% compared to 9.3% for stocks & bonds and 6.2% for risk parity. Stocks also suffered a maximum drawdown of over 50% compared to 30% for stocks & bonds and 15% for risk parity.

Although stocks had the greatest absolute return, they had the lowest Sharpe Ratio, or return efficiency. The right column shows global stocks had a Sharpe Ratio of 0.41 compared to 0.53 for stocks & bonds and 0.65 for risk parity.

Why should you care about the optimal portfolio?

There’s an old saying in investment circles: “You can’t eat relative returns.” Or, “You can’t eat Sharpe.”

What’s meant by these expressions is that it’s ultimately the absolute returns that investors “eat”, not the risk-adjusted returns (highest Sharpe portfolio).

The Sharpe Ratio and other risk-return metrics are interesting, but what's most-valuable is the ultimate return investors earn.

In the previous example, the 100% stock portfolio grew from $10,000 to nearly $75,000 during the nearly 30-year time period. Although the Risk-Parity style portfolio had a higher Sharpe Ratio, $10,000 only grew to $51,547. Yes, the extra 1.5% per year for stocks was achieved with a lot more volatility, but resulted with a lot more for the investor to eat!

This reality has led investors with long time horizons to opt for 100% stock portfolios (or thereabouts) in an effort to achieve the highest absolute returns.

But what if you could preserve the risk-return relationship of the optimal portfolio and target higher returns?

Using Capital Efficiency to Target Higher Returns

An alternative to holding stock-centric portfolios to target higher returns is to hold more of the optimal portfolio. This requires capital-efficiency, or leverage.

In the graphic below, the capital-efficient approach follows the dashed line, while concentrating into stocks follows the solid line. Concentrating into stocks has historically offered higher returns than the more diversified 60/40 portfolio or Risk Parity portfolio, but with significantly more risk.

Using the risk parity style portfolio plus capital efficiency is expected to increase returns with a better risk profile. Investors should desire portfolios up and to the left of the graph below, earning a (1) similar or greater return with (2) similar or less risk.

The investment efficient frontier comparing stock portfolios, 60/40 portfolios, and risk parity style portfolios with leverage.

Let’s go back to the comparison of the 100% global stock portfolio, 60% stocks and 40% bonds portfolio, and risk parity-style portfolio (30% stocks, 55% bonds, 15% gold).

Investment performance comparison of stocks, a 60/40 portfolio, and a risk parity style portfolio.

Performance of global stocks, 60% global stocks & 40% bonds, and a risk parity style portfolio composed of 30% global stocks, 55% bonds, and 15% gold from May 1996 through December 2023. Global stocks are composed of 60% U.S. Stocks (VTSMX) & 40% International Stocks (VGTSX). Bonds are proxied by Vanguard Interm-Term Treasury Inv (VFITX). Gold is proxied by the Gold Fixing Price in London Bullion Market 3:00 PM (London time) through 2004 and SPDR Gold Shares (GLD) from 2005 to present. All portfolios are rebalanced annually.

By both standard deviation and maximum drawdown metrics, the risk parity-style portfolio is about 1/3rd as risky as 100% stocks and 2/3rds as risky as the 60/40 portfolio.

If you want to target a higher return than the risk parity-style portfolio offers and preserve the superior risk-return relationship of the risk parity-style portfolio, then you should use leverage instead of concentrating into stocks.

For example, you could borrow 50% of your capital to invest in 45% stocks, 82.5% bonds, and 22.5% gold for a total exposure of 150%. Assuming you can borrow at the cost of cash, or the risk-free rate, the resulting return statistics are as follows:

Investment performance comparison of stocks, a 60/40 portfolio, and a levered risk parity-style portfolio.

Performance of global stocks, 60% global stocks & 40% bonds, and a levered risk parity style portfolio composed of 45% global stocks, 82.5% bonds, and 22.5% gold, -50% cash (3-month Treasury Bills) from May 1996 through December 2023. Global stocks are composed of 60% U.S. Stocks (VTSMX) & 40% International Stocks (VGTSX). Bonds are proxied by Vanguard Interm-Term Treasury Inv (VFITX). Gold is proxied by the Gold Fixing Price in London Bullion Market 3:00 PM (London time) through 2004 and SPDR Gold Shares (GLD) from 2005 to present. All portfolios are rebalanced annually.

In this example, the 1.5x levered risk parity-style portfolio now has the highest absolute return of 7.9% compared to 7.5% for stocks and 6.8% for stocks & bonds. And the 1.5x risk parity portfolio achieves these returns with less risk than the alternative portfolios.

Below are the month-end drawdowns of the three portfolios. Despite the use of leverage, the risk-parity style portfolio suffered significantly less severe drawdowns than the global stock and bond portfolios.

Investment drawdown comparison of stocks, a 60/40 portfolio, and a levered risk parity style portfolio.

So with the use of prudent leverage, the old expression “You can’t eat relative returns” doesn’t hold up.

How to Apply Leverage to the Optimal Portfolio

In order to put this theory into practice, you need to be able to borrow at a competitive rate. The previous example assumed the risk parity-style portfolio’s leverage was acquired at the cost of cash, or the risk-free rate. If your cost to borrow is well-above the risk-free rate or the return of your investment portfolio, this strategy quickly falls apart.

Until recently, this cost of leverage has been the main hurdle for the average investor to implement this strategy.

However, recent changes in the ETF landscape have opened the door to low-cost borrowing for all investors. Now, individual investors have access to ETFs with (1) institutional-level borrowing costs and (2) non-recourse leverage.

This means investors may access cheap leverage without being subject to margin calls. Investors are only risking the capital they invest in the funds.

By combining funds with embedded leverage, individual investors may now put this theory into practice. Individual investors have another option when targeting higher returns. Instead of investing heavily in stocks, which have been subject to major declines, investors may choose to apply leverage to a far more balanced and economically resilient portfolio.

Key Takeaways for Investors

Thanks to increased access to capital-efficient investment approaches, virtually all investors now have a viable alternative to stock-centric portfolio allocations.

While a stock-centric allocation has worked incredibly well over the last decade, it has not been without its drawdowns and periods of panic (i.e. COVID). And the first decade of the 2000s was an incredibly trying period for stock-centric investors. The S&P 500 declined 1.0% per year from 2000-2009 (before inflation) and was subject to two gut-wrenching drawdowns of -45% during the Dotcom Crash of January 2000 through September 2002 and then the Global Financial Crisis decline of -51% from November 2007 through February 2009.

A combination of a more efficient ("optimal") investment portfolio and capital efficiency allows investors to target higher returns with a smoother ride.