Which Type of Portfolio Might a Young Investor Who Is Not Afraid of Risk Choose? The typical portfolio of a young investor who is not afraid of risk will, of course, have a large allocation to risky assets. Assets that have a higher risk factor also have higher returns. It is part of modern portfolio theory that investors will want greater rewards for holding riskier assets.
Young investors generally have a longer time horizon to hold their assets. The idea is that an investor creates a portfolio to manage investments that will help or finance their lifestyles once they reach retirement age.
Which Type of Portfolio Might a Young Investor Who Is Not Afraid of Risk Choose?
So, having a longer time horizon over which you can hold risky assets means you can ride out any downturns which may occur. Traditionally investors consider stocks as risky assets, and bonds as relatively safe. However, other risky assets have appeared over the past decade, and others have become more accessible.
We’ll take a look at which type of portfolio might a young investor who is not afraid of risk choose. And we will also consider some of the riskier assets individually. But first, we need to determine what “not afraid” of risk means.
Determining Risk Aversion
Risk aversion is the measurement that defines how much risk you are willing to assume when you make your investments. The higher your risk aversion the less you will want to hold risky assets. Risk-averse investors want assets that do not have large deviations from their average returns.
Stocks, for example, have large deviations from average returns. This factor can produce higher returns than US treasuries but can also produce much larger losses. A risk-averse investor will want to hold very little in stocks and a much larger allocation to treasuries.
However, if you consider yourself as not afraid of risk, does this mean you should invest all your money in risky assets? Well, the answer to that is quite simple, no. Even if you have zero risk aversion, would you throw all your money on a sports bet? Or take all your cash to the casino one night to play roulette?
We all know no person in their right mind would do that. So, the definition of “not afraid” in reality means that you have a very low level of risk aversion. In the sense that you might want to invest a very large amount of your money in risky assets.
But as the saying goes, never put all your eggs in one basket, so you will still invest a portion of your cash in various assets. Investing across a broad range of stocks helps diversify your risk in stocks. However, you also need to invest in other assets to diversify the overall risk of your portfolio.
Traditional Stock and Bond Portfolio
Traditional portfolios are typically divided by allocations to two assets. One asset is risky, and the other is considered risk-free. The risky asset is stocks, or funds that invest in stocks, either by tracking an index, or that have some kind of managed approach.
The risk-free asset is cash and US treasury bonds or notes. Debt issued by the US government in reality still has some risk but is considered risk-free for portfolio construction. The view that US treasuries can be seen as risk-free comes from the extremely low probability of default attributed to the US government debt.
Traditional Portfolio Plus Alternative Assets
Which type of portfolio might a young investor who is not afraid of risk choose? We feel that the answer to this question includes a very high percentage of funds allocated to risky assets. However, not all of that cash has to go into stocks.
You can also consider some alternative assets classes, which are riskier than treasuries or cash, and also have historically higher returns. Let’s take a look at some of the asset classes in the alternative investment space.
Digital currencies are relatively new as an asset class. Investors started exchanging Bitcoin in January 2009. But the attraction of decentralized payments and the value of blockchain technology in other fields have given rise to a slew of other digital currencies.
Together with the hundreds of new virtual currencies, we have seen an ever-wider acceptance of digital money. Many stores have started accepting payments in Bitcoin such as Microsoft or Overstock to mention a couple.
Some countries, such as China, are beginning to look at their own sovereign cryptocurrency. And El Salvador has even adopted Bitcoin as legal tender. The elimination of middlemen and the reduction of transaction costs are big factors in the rise in the popularity of cryptocurrencies.
It looks like cryptocurrencies are around to stay, and Bitcoin for its limited supply and its starter privilege seems set to remain the gold equivalent of the digital currency realm. Investing in cryptocurrencies is very risky, and price moves are extremely large. We recommend caution when deciding how much cash to allocate to this new asset class.
Managed futures are funds that invest in futures contracts only. They cover a wide variety of asset classes in the underlying market. Funds may invest in futures with underlying markets in foreign exchange, commodities, stocks, and bonds.
These funds are also sometimes known as CTAs (Commodity Trading Advisors). Depending on the firm, you have minimum buy-ins for SMAs as low as $10,000 and as high as $1,000,000. You can also find CTAs that are set up as ETFs, which avoids the minimum buy-ins and allows you to invest and divest with ease.
CTAs are actively managed and are very similar in their trading to hedge funds. They use large amounts of leverage which is supplied using futures contracts. So, investing in this type of asset is very risky.
Most of these funds consider themselves as having a systematic strategy. That is, they follow a predesigned formula for entry and exit in their trading. Others have a discretionary approach, and the trading strategy is not predesigned altogether.
Precious metals have been around since the dawn of civilization and have from the beginning held the capacity to store wealth. We know the value of this asset over time is undeniable. We have seen gold priced at $42.73 in August 1974 go to its all-time high of $1920,80 in September 2011.
I mention August 1971, because that was the time President Nixon ended the convertibility of gold. Since the value of gold has been allowed to float, the precious metal has had some bumpy rides. However, it has still increased by multiples of its value from 1971.
Other precious metals are also a valid option when constructing your portfolio. Platinum, palladium, and rhodium are possibly the ones investors take more interest in. You can buy physical metals and that gives you safety from a total collapse.
Or you can invest in precious metals through an ETF with a specific mandate. The fund may invest in gold only or a variety of precious metals. ETFs, bring the advantage of the ease of investment. You won’t have to buy a safe or hire a storage company to keep your investment.
However, it does come with corporate and market risk. The corporate risk rises from the possibility of bad governance or fraud. While the market risk comes from the fact that ETFs are stocks and may suffer also in the event of a stock market selloff.
This is where you have to decide how you are going to split your cash among a variety of assets. The first decision to make is how much of your portfolio you will invest in risky assets. As an investor with a considerable high-risk appetite, the percentage will be large.
How large depends on things like how much cash you want to keep at hand, or how much are you willing to see your portfolio shrink by say 40% if there is a stock market crash. Having your money in risky assets means that there is a possibility that at some point you may see your savings losing by say half of their value.
As a young investor, you do have time on your side. When it comes to investing, staying power is your greatest ally. If you can ride out any period of adversity by just sitting put, you are very likely to still come out on top at some point.
Also, if you add funds to your portfolio regularly throughout the year, you will buy assets when they are cheaper. If the financial markets have a rough time, as they do occasionally, by continuing to add to your investments you are buying at cheaper and cheaper prices.
This practice should happen naturally if you want to keep your asset allocation in line. Let’s say once a year you analyze your portfolio. You see that risky assets decreased in value by 30% and treasuries stayed about the same.
Your portfolio is now unbalanced, you started with 80% of risky assets, 15% treasuries, and 5% in cash. But since the risky assets have lost 30% in value your portfolio has a higher percentage of treasuries and cash.
To rebalance your portfolio to the original 80-15-5 split you would need to buy more of those risky assets to bring all the three ratios back into line.
The pie chart above is an example of a portfolio allocation to assets split between risky, treasuries, and cash. The allocation in the pie chart is not conclusive, it is simply an example of a portfolio for an investor who is not afraid of risk.
We advise that caution should always prevail, however, speak to your financial advisor to best determine your exact needs.
Allocations Among Risky Assets
You can break down your allocation to risky assets across a variety of assets, traditional and alternative. The pie chart below is an example of allocations to the risky assets of a portfolio with a high degree of risk tolerance.
The pie chart below again is not conclusive but simply an example of how you could distribute allocations to risky assets within your portfolio. We used the highest allocation for stocks, but that doesn’t necessarily mean it is your choice also.
Some investors split their money evenly between stocks and managed futures for example. This type of portfolio is even riskier than the one outlined below. Always speak to your financial advisor before making any final decision, to best determine what asset mix is right for you.
Why Not Just Hold Stocks?
If you only held stocks, even 100s of them, say through a broad index tracking fund, you are exposed to a possible financial crisis with everything you have. As long-term investors, no matter how unafraid of risk you are, it makes all the sense to diversify your risk across multiple assets.
Adding assets like CTAs, cryptocurrencies, or precious metals greatly reduces your dependence on the stock market for returns. These assets have little to no correlation with the stock market. Low correlation means that despite a possible poor stock market, the returns of these alternative assets may still show positive results.
Investing in stocks and other assets such as managed futures, gold, or cryptocurrencies carries a considerable amount of risk. Baring that risk is what produces higher returns when compared to treasuries.
If you are a young investor time is on your side as we have seen that most financial crises are overcome within years. And even with large selloffs such as the 2008 crisis, the stock market rallies to its previous high within several years.
If you are thinking of investing for your retirement, setting up an IRA brings the advantage of a tax-deferred environment where your investments can grow tax-free.