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The first step in building an investment portfolio is to understand your true risk tolerance before investing. How much risk can you tolerate both in theory and in practice? It is easy to fall a victim of being a risk taker on paper but realize risk aversion in reality. When the stock market enters a correction territory by falling more than 10%, the feeling of anxiety may cause you to fall victim to the loss aversion bias. Loss aversion expresses the intuition that a loss of $X is more aversive than a gain of $X is attractive (Daniel Kahneman and Amos Tversky, 1984). It will be the least favorable time to change your portfolio when the prices are down. If you are feeling difficulty to remain calm and rational during volatile times or simply are against taking too much risk with your savings, you should have a diversified portfolio with a comfortable risk profile.

A diversified portfolio should aim to achieve a positive risk-adjusted return, as measured by the Sharpe Ratio. The goal is to reduce overall portfolio volatility while maintaining attractive returns. Historically, combining U.S. equities with long-term U.S. Treasury bonds helped achieve this balance. However, as market conditions evolve, so does the risk-return profile of each asset class.

For example, from January 2020 to December 2024, the iShares 20+ Year Treasury Bond ETF (TLT) delivered a negative Sharpe Ratio of -0.53, indicating that it failed to compensate investors for the risk taken. In contrast, gold (IAU) produced a Sharpe Ratio of 0.62, offering better risk-adjusted performance during this time (see Table 1).

To explore this further, I ran a simplified optimal asset allocation analysis using only three asset classes: U.S. equities (IVV), long-term U.S. Treasuries (TLT), and gold (IAU). The optimal portfolio allocation for maximizing the Sharpe Ratio was 41% in IVV and 59% in IAU. This portfolio delivered a Sharpe Ratio of 0.60, with an annualized standard deviation of 13.61% and an expected return of 10.54% (see Table 2).

Importantly, the portfolio’s standard deviation (13.61%) was lower than that of either gold (15.48%) or U.S. equities (21.36%) individually. At the same time, the portfolio’s expected return of 10.54% was still quite competitive compared to 9.57% for gold and 11.96% for the S&P 500 Index. By combining IVV with IAU, we effectively reduced volatility without sacrificing returns much. This highlights how diversification, specifically, blending uncorrelated asset classes with positive Sharpe Ratios, can improve risk-adjusted performance. For risk-averse investors, this type of portfolio construction process offers a smoother ride and can help them stay invested through market fluctuations. You may consider adding additional asset classes to further diversify risk while aiming for an attractive expected return.

In addition to a diversified portfolio, a risk-averse investor should also use regular rebalancing. Periodic rebalancing is an additional risk management tool. Rebalancing is bringing out-of-balance securities in your portfolio in line with the original target allocation. In order to rebalance, you would sell overweight securities and buy underweight securities to bring the overall allocation in line with your original target. You should rebalance regularly, at least monthly. The advantages of rebalancing are that you will be selling high and buying low. This strategy will limit your risk by trimming gainers and not letting one security to become a large single risk factor in your portfolio. The downside of rebalancing is tax implications. If you have a taxable account, every time you sell the appreciated stock, you will owe tax to the IRS. However, if you have a tax-deferred or a tax-exempt account, such as an IRA, Roth IRA, 401k, Roth 401k, capital and income gains are tax-exempt. You will pay tax on future cash distributions.     

References:

Daniel Kahneman and Amos Tversky. Choices, Values, and Frames. 1983. https://www.columbia.edu/itc/hs/medinfo/g6080/misc/articles/kahneman.pdf

Disclosures:
The analysis is based on historical data and future expectations that may not be correct. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor before making an investment decision. Neither ECNFIN.COM nor its author is responsible for any damages or losses arising from any use of this information. Past performance doesn’t guarantee future results.

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