How to Balance Risk and Return in Your Investment Portfolio

Key Takeaways

• When establishing an investment portfolio, the two chief investor goals are usually to generate robust long-term returns and mitigate loss exposure. 

• Opportunities in alternative assets are no longer limited to the ultra-wealthy or institutional class and may now be accessed by retail investors.

• One of the most important things for each investor to consider when building a portfolio is their personal risk tolerance, since that will help determine possible investment options.

The following information can help retail investors learn more about investment return and risk, what a balanced portfolio is, and how to build a portfolio that leverages alternative investments.

Investment Risk and Return Explained

It is vital that every investor understands a portfolio’s risk and return. In general, risk and return is the relationship between the amount of return an investment provides and the level of risk undertaken in the investment.

The rule of thumb is that the higher the sought-after return, the more risk that must be undertaken. 

Risk Tolerance

One of the most important things for each investor to consider when building a portfolio is their personal risk tolerance, since that will help determine possible investment options. Thus, it is important for investors to determine whether their tolerance is low, high, or somewhere in between.

Risk tolerance is one’s ability and willingness to, in exchange for the potential for higher investment returns, accept investment losses.

One’s tolerance is connected to their time horizon – the amount of time that is left before a financial goal such as retirement – and how watching the market’s constant rise and fall affects them mentally. And if that goal is several years away, there is more time to withstand such fluctuations and possibly benefit from the market’s general upward trajectory. 

Investment Portfolios

Basically, an investment portfolio refers to all one’s invested assets. The collection of assets can include investments such as stocks, bonds, exchange-traded funds, and mutual funds.

Building a healthy, balanced investment portfolio, though, requires deliberate effort. Say the investor wishes to invest in stocks, bonds, and alternative assets. Deciding precisely how much of each asset class one includes in their portfolio is called “asset allocation,” which is highly reliant upon risk tolerance.

There are various ways allocation is approached, with one rule of thumb calling for subtracting one’s age from 100 or 110 to establish how much of one’s portfolio should be comprised of stocks. For those who are just beginning to craft their portfolio, it may be constructive to consider various model portfolios – aggressive, moderate, and conservative — to gain a framework for their own asset allocation efforts.

Do note that while models can be helpful in terms of allocation, they may not fit one’s personal risk tolerance.  With that in mind, there are ways to de-risk one’s portfolio, including investing in stocks through funds that hold a collection of stocks from a broad variety of public companies. Such funds can be ETFs, mutual funds, or index funds. In particular, mutual funds tend to be less risky than individual stocks.

Further, investing in fixed-income investments – bonds – can offset riskier investments in one’s portfolio. Investors can also decrease overall portfolio risk by adding alternative assets. 

Over time, the investor should rebalance their portfolio as needed to keep allocation proportions from being disrupted. Such rebalancing is typically done at regular intervals, such as every six months or once annually.

Understanding Efficient Frontier 

A pillar of the modern portfolio construct, the efficient frontier theory was introduced in 1952 by Nobel laureate Harry Markowitz. Essentially, the efficient frontier is made up of investment portfolios that provide the highest expected return for a certain risk level. It rates portfolios on a scale of return (y-axis) versus risk (x-axis).

Because they carry a higher risk level for the defined rate of return, portfolios positioned under the efficient frontier are deemed sub-optimal. Those that sit to the right of the frontier are viewed as suboptimal for a different reason: a higher risk level for the defined rate of return.

Essentially, Markowitz’s theory posits that one can design an optimal portfolio that perfectly balances risk and return. Such a portfolio seeks to balance securities with the greatest prospective returns with a tolerable degree of risk with the lowest degree of risk for a given level of possible return.

Adding Alternative Investments to Your Portfolio

When establishing an investment portfolio, the two chief investor goals are usually to generate robust long-term returns and mitigate loss exposure. 

The ultra-wealthy excepted, most portfolios have traditionally consisted of a diversified set of stocks and bonds. While stocks can generate large, long-term returns, they do carry high risk. And while bonds have less risk, they generally produce smaller returns.

For the ultra-wealthy, there has always been an additional option – private-market alternatives. Because of their low correlation to public markets, alternatives such as art and real estate are generally less volatile (risky) and can provide protection against inflation or economic downturn. They can also potentially provide high, regular returns.

Further, the traditional “60/40” portfolio, comprising 60% stocks and 40% bonds, is increasingly eschewed in favor of holdings that decrease risk and increase expected return. For example, a 50/30/20 portfolio can provide an expected increase in returns of about 1% while lowering the expected risk by 10%. More on portfolio construction later.

What is key here is that opportunities in alternatives are no longer limited to the ultra-wealthy or institutional classes.

Increased Access to Alternatives

Since its 2015 founding, Yieldstreet has been steadily democratizing access to alternative markets that were previously the exclusive province of the wealthiest 1%. 

The Yieldstreet platform, on which nearly $4 billion has been invested to date, offers the broadest selection of opportunities available, with assets including transportation, private credit, short-term notes, and more. 

Yieldstreet offers a net annualized return of more than 9% on its highly vetted opportunities with returns exceeding $2.3 billion. To access tools for portfolio optimization that once were only available to the ultra-wealthy, retail and accredited investors would do well to explore these options. 

Note, too, that Yieldstreet’s offerings can generate bond-like diversification benefits sans the low returns of corporate and government bonds. In fact, creating a portfolio of varying asset types to lessen risk is foundational to long-term investing success.

Portfolio Diversification and Alternative Investments

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

In Summary

A properly balanced portfolio can decrease risk while increasing expected return.  Contrary to some sentiment that alternatives do not work in a risk-off environment, adding alternatives to holdings can actually de-risk one’s overall portfolio.