Optimal Risk Portfolio

            In order to create the best portfolio for each individual client, goals have to be set for the investment. Some clients saving for there retirement in there early thirties will be better off with higher risk to allow the initial capital to grow more as the volatility of the market won't affect there portfolio in the long run. Others closer to retirement need a steadier investment that can provide an income. Bonds are an potential solution to achieve this goal.When investing bonds offer a lower risk investment that isn't as volatile as the stock market. Vanguard offers an ETF of United States investment grade bonds that mimics the entire U.S. bond market. Bonds offer a steadier source of income than stocks, helping investors reach long-term goals. The downside of bond are they don't provide same opportunity for growth as stocks. The BND exchange traded fund has an average annual return of 3.83%

To build the optimal risk portfolio of SPY and BND lets compare 100 portfolios with 0%  BND and 100% SPY all the way to 100% BND and 0% SPY with a risk free rate of 0%. If you refer to my previous article about SPY it is an ETF that mimics the S&P 500 which is made up of 500 U.S.large cap  stocks. Comparing these to large ETFs that mimic the stock and bond market will simplify the comparison instead of complying a portfolio of diversified bonds and stocks. The average monthly return for SPY is 0.75% compared to only 0.29% for BND. SPY offers nearly three times the return. BND offers a standard deviation of .0107 compared to .0425 for SPY displaying that is more consistent result. Correlation coefficient between SPY and BND is -.0002892 displaying there is not a strong correlation between the returns of the two ETFs. The portfolio with the most optimal risk would be 86% BND and 14% SPY. This portfolio provides a return of 36%. While this isn't the allocation with the highest return it has the best return to risk ratio when the risk free rate of 0. When you adjust the risk free rate to that of U.S. Treasuries of 0.1% the optimal portfolio allocation changes to 83% BND and 17% SPY with a return of 38%.

The Sharpe Ratio which measures the excess return of this portfolio accounting for risk is .843 for the year which is good not great. A portfolio with a higher Sharpe ratio is SPLV which is compromised of the 100 stocks in the S&P 500 with the lowest volatility. SPLV has a Sharpe ratio of 1.25, which is 48% better than a portfolio compromised of 83% BND and 17% SPY. The average annual return of SPLV is 12% compared to 13% for SPY during that same time frame. SPLV standard deviation is .025 compared to SPY of .0425 which is why SPLV has provided a greater excess return for the rick taken. SPLV is weighted almost evenly among the 100 least volatile stocks in the S&P 500 and isn't weighted based on market capitalization.

Uncertainty exists with every investment and the possibility of the risk free rate rising needs to be considered. If the rate rises to 1% it will erase the excess return for bonds and you should allocate you portfolio to almost entirely SPY. If the rate rises to 1% I would pick to add a stock that has a negative correlation to BND and SPY because as rates rise there excess return above risk starts to become negative. If you are able to short sell stocks I would short BND ETF as the value of bonds decreases as interest rates rise and the Federal reserve is currently in the process of slowly raising rates to limit inflation.