Risk-budgeting your rookie portfolio

An important consideration for a retail investor is the question of how to keep your portfolio safe against a future downturn. One approach that I find dubious is to keep an eye on political and economic events and sell the portfolio before the foreseen event were to happen. The pandemic taught us that such an approach might not work because no economic indicator could have predicted the rise of COVID-19.

An alternative is to perform risk-budgeting. In such an approach, you limit the risk of your portfolio to something which you can stomach. If you track your portfolio on Stocks Café, a straightforward risk metric is the concept of a significant shortfall.

The effective shortfall, expressed as a percentage measure, measures the expected loss of your portfolio on the worst month that occurs out of a hundred months, which must be something that you must be able to tolerate daily. If your effective shortfall is too massive, you will lose sleep every night.

The following diagram shows a $15,000 portfolio of stocks, REITs and business trusts built by Batch 17 students of the Early Retirement Masterclass (ERM) program. Also, note that the overall current yield is approximately 4.52%.

The expected shortfall is 18.59%; this means that during the worst month that occurs over the next eight years, students need to be able to stomach an 18.59% loss.

The loss may not be something that is not acceptable for everyone. All investors have different risk preferences and, in my case, this is a portfolio leveraged at an equity multiplier over 1.9.

So the first step in refining the portfolio is to determine what expected shortfall is tolerable. In this article, suppose I would prefer an expected shortfall below 15%.

The next question is, how do we reduce the expected shortfall?

Two candidates can be introduced into an Interactive Brokers margin portfolio to lower the expected shortfall of the portfolio, they are:

• ABF SG Bond ETF (Ticker : A35) or,
• NikkoAM SGD Investment Grade Bond ETF (Ticker : MBH).

Thanks to the low margin financing rates of Interactive Brokers, both ETFs can now be introduced to stabilise the collateral of the margin account without incurring net margin financing losses.

To answer the question as to whether which ETF is the better diversifier, we measure the correlation between the STI ETF against the two counters. The lower the correlation between the Bond ETF and the STI ETF, the more effective it is as a diversifier.

As it turns out, ERM students have an in-house tool built by me (currently on beta) to do this:

Based on about 2 years worth of data from 2018 to the present, A35 or the ABF SG Bond ETF has a correlation of -0.18 against the STI ETF.

What this means is that we can introduce the ABF SG Bond ETF into the Batch 17 ERM portfolio gradually to reduce the expected shortfall of the portfolio.

We can start with a purchase of 1,000 shares of A35 to test the waters.

This is how Stocks Café recalculates the risk of the portfolio:

We can reduce the expected shortfall is reduced to 16.56% from 18.59%. This 2% reduction comes at the expense of accepting lower yields. The current yield has fallen from 4.52% to 4.32%.

Eventually, we can get our effective shortfall to below 15% at 14.79% by buying 3000 units of the Bond ETF. Consequently, we end up reducing the current yield of the portfolio to 4% as part of this exercise.

I hope that the reader can appreciate the changes in the investment landscape to allow this form of risk budgeting to be performed by a retail investor.

1. Stocks Café must have the means of measuring the risk of the portfolio of a rookie investor.
2. A community of students must be able to derive the correlation coefficients of different instruments to determine which instruments can be best used for risk reduction.
3. Our markets must have a decent range of instruments that are low or negatively correlated with the main index. Fortunately, the ABF SG Bond Fund serves this purpose very well.
4. For margin account investors, financing rates must be low enough not to penalise an investor for adding a bond ETF to a leveraged portfolio. This only came about recently because Interactive Brokers charges less than 1.6% for the margin financing rates.

Finally, in the process of protecting your portfolio, the lowering of risks come at a price, more stable portfolios generally produce lower dividend yields.