One of the greatest challenges for investors today is constructing low-risk portfolios that provide the best returns using low-cost funds or exchange-traded funds (ETFs). Doing so requires advisors to define risk as the potential for retirees to fail to achieve their financial goals, instead of as volatility, as it is traditionally measured. I will show how to construct a low-cost portfolio that minimizes this definition of risk while generating a reasonable real return.

Market conditions are challenging the notion of what a conservative portfolio looks like. Bond yields are historically low and the expected real yield of Treasury inflation-protected securities (TIPS) is below zero for short-term maturities. Burton Malkiel argued that Treasury bonds are actually a very risky asset class in present conditions. A number of influential money managers have been making this point for years, and the ongoing decline in yields means a small increase in interest rates could make the real yield of bonds negative.

Before discussing what a conservative portfolio looks like, let’s consider what such a portfolio means in terms of risk of loss. Conservative does not mean risk free. Investors who require a near-zero real return will be safest in a 100% TIPS portfolio. For those who need their portfolios to deliver a positive real return, what is the low-risk alternative?

A standard way to describe the risk level of a portfolio is in terms of the worst 12-month loss that can reasonably be sustained without impairing the ability of the investor to meet his or her goals. A survey of pension plan consultants conducted by PIMCO’s defined contribution group suggests a consensus view that 65-year-olds can sustain a maximum one-year loss of no more than 5% of their portfolios and still meet long-term goals. For a 55-year-old, the consensus maximum acceptable loss level came in at between 5% and 10%.

I will begin by discussing the requirements of a conservative portfolio, and then compare today’s conservative allocation funds to a baseline stock/bond mix. I will develop a conservative baseline portfolio based on an estimated range of potential loss levels associated with a number of traditional safe asset allocations, in light of current market conditions. I will then show how a better portfolio can be constructed using a series of broadly diversified ETFs.

Features of a safe portfolio

A conservative portfolio must meet four criteria:

  1. Have an acceptable loss potential.
  2. Provide meaningful income to reduce the need to sell in a declining market.
  3. Maintain a neutral or positive correlation to interest rates.
  4. Offer a positive expected real return.

Let’s assume an acceptable portfolio has a maximum expected loss of 10% over a 12-month period. This is the lowest level that allows the portfolio to have a reasonable chance of generating meaningful positive real returns, as I will demonstrate.

One key risk is the need to sell in a declining market. A conservative portfolio must generate meaningful income to defend against this scenario.

A conservative portfolio needs to target positive, or at least neutral, correlation between its returns and changes in bond yields and other measures of interest rates.