To accurately answer the preceding question, we must define risk. Volatility is not the only—or even the most relevant—measure of risk. For long-term investors, risk is more about failing to meet wealth accumulation goals than about short-term changes in the price of a portfolio. A better measure of risk than annual volatility is the estimated probability of reaching or failing to reach the desired or, more important, needed long-term real return level.
Using our estimates of risks and returns, investors in the Maverick portfolio should be 95% confident of reaching or exceeding an annualized 10-year real return of 1.3%. In contrast, investors in the 60/40 portfolio have a 50% probability of failing to exceed a 10-year real return of 1.3%. From this perspective, such a high probability of low or zero real returns is not low risk! For the long-term investor, the 60/40 portfolio presents the highest risk of failing to accumulate wealth.
Why does the 60/40 portfolio seem safer? This traditional investment portfolio protects the investor from having to accept maverick risk—a conceptually uncomfortable position for many investors. As John Maynard Keynes wrote in 1935 in his well-known tome Theory of Employment, Interest, and Money, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
We will have more to say about maverick risk in forthcoming articles and in the information provided on our Asset Allocation site in the months ahead.