Put stocks into risk-level buckets

In this lesson we learn about how to use risk tolerance to create five risk buckets from conservative to aggressive (low to high risk). Ranking stocks by volatility, the entire market is divided into five risk buckets. We explain their features and show you how to create the basis of a portfolio for each risk bucket and populate them with stocks.

What are risk buckets?

The iron law of investment is that to earn higher returns an investor must take more risk. The level of risk an investor is willing to bear in the expectation of a given return is known as risk tolerance.

Depending upon on where one is positioned on this risk spectrum, an investor will seek out share holdings that meet the targeted investment objective and risk-return profile.

How volatility can be a partial proxy for risk

Volatility is a key proxy for risk. The more volatile a share price, the higher the risk to shareholder returns, although investment horizon (how long the stock will be held in the portfolio) is a factor here; long-term investors will be less concerned by bouts of short-term volatility..

To create our risk buckets we used as a baseline the Stockopedia Risk Rating.

The division of the rankings into the five risk groupings are not dependent on Stockopedia.

The risk rating ranks stocks by 3-year normalised (standard deviation of daily returns time series) volatility but the risk bucket screener ranks for 1-year volatility.

But volatility by itself can’t be relied upon because it really is only telling the investor what the market thinks about how risky a stock is- that is different from a measure of how risky a stock actually is.

More importantly perhaps, a volatility-centric view is at odds with the fact that increasing volatility (higher risk) leads to smaller risk adjusted returns (measured by the Sharpe ratio).

Why investors don’t rely on volatility alone: quality value growth and momentum

This divergence from our so-called iron risk-return law is explained by a tendency by the investors for a bias towards overpricing speculative or high growth potential stocks. This happens for a variety of reasons, including investment firms and brokers’ systemic bias towards placing riskier buying opportunities in front of their clients, with bonus systems that remunerate that behaviour. Investors are also less inclined to leverage positions in lower volatility shares and investors are generally willing to pay more now because they hope for a later windfall.

With this in mind, the risk groupings below need to be viewed in conjunction with Quality, Value, Growth and Momentum.

Stockopedia’s StockRank is helpful here as it is an equally weighted combination of the ValueRank, QualityRank and the Momentum Rank. These three basic ranks are computed for every company in the market on a daily basis, summed and then re-ranked as a percentile from 0 (worst) to 100 (best).

The StockRank, says Stockopedia, is based upon the three of the strongest ‘anomalies’ in finance:

• Quality (risky stocks don’t pay),
• Value (cheap stocks beat expensive stocks) and
• Momentum (winners beat losers).

Below we show how those groupings map to our slightly different labelling:

• conservative (lowest volatility 10% of the market) – > conservative
• balanced (next lowest 15% of the market) – > moderately conservative
• adventurous (next lowest 20% of the market) – > moderate
• speculative (lowest volatility 25% of the market) – > moderately aggressive
• highly speculative (lowest volatility 30% of the market) – > aggressive

The five classifications (from least to most volatile) are Conservative, moderately conservative, moderate, moderately aggressive and aggressive.

The top decile comprises the most conservative 10%, the next 15% is moderately conservative, 20% moderate, 25% moderately aggressive and 30% aggressive. Stockopedia uses proprietary measures of volatility, which account for the fact that some stocks have shorter histories and/or are traded less frequently than others.

Conservative

The conservative investor emphasises capital preservation over high returns that might risk the principal. Comfortable to accept low returns for higher liquidity and flexibility. Targets income (for reinvestment and/or consumption needs) and some capital growth.Fall less in negative markets, but rise more slowly in bullish markets. These stocks will tend to over-perform over the long term.

Moderately conservative

Moderately conservative investors emphasise capital preservation but willing to take on a small modicum of risk and accept some volatility for an element of capital growth. The investor is comfortable accepting a small degree of risk and volatility to seek some degree of appreciation. Requires greater liquidity and will accept lower returns for minimal risk. Targets a mixture of income yield and capital growth. Outperform during ‘risk on’ rising markets, but fall faster and harder in ‘risk-off’ downturn periods.

Moderate

Moderate investor seeks to reduce risk while enhancing returns. Will accept modest risks for higher long-term returns. A Moderate investor will accept short-term loss of principal and lower liquidity in exchange for long-term capital appreciation. Requires reasonable, relatively stable income and capital growth.

Moderately aggressive

A moderately aggressive investor seeks higher long-term returns and will accept considerable risk in that quest. Will endure short-term losses of principal and volatility for long-term capital appreciation. Liquidity is not a primary concern. Targets income and capital growth. Income reinvested.

Aggressive

Aggressive investors are willing to take high risk to maximise long-term investment returns. Puts a priority on maximising long-term returns over capital preservation. Liquidity is not a consideration. Aggressive investors are willing to contend with high levels of volatility and losses of principal. Targets capital growth. Income reinvested.

Conservative stocks

Companies that have demonstrated steady growth in revenue and profit over a long period of time. They are reliable businesses that have well-established business models and are considered to be lower-risk investments. Large caps predominate.

Risk rating:

conservative

Screener:

bottom 10% of market ranked by volatility

Market value grater than £10 million

Excludes financials

BuyShares Conservative Portfolio screen example

BuyShares Conservative Portfolio – Quality, momentum, value, growth scores:

Moderately conservative stocks

Shares of those companies that exhibit below-market volatility, and have firm long-term consistent earnings. A mix of large cap companies with established positions in their markets and, have quality balance sheets and strong management.

Risk rating:

balanced

Screener:

next 15% of the market ranked by 1-year volatility

market cap greater than £10 million

exclude financials

BuyShares Moderately Conservative Portfolio screen example

BuyShares Moderately Conservative Portfolio – top 50 of 106 members

BuyShares Moderately Conservative Portfolio – Quality, momentum, value, growth scores:

Moderate stocks

Will hold a blend of large and a minority of mid cap stocks.Seeks out cash-generative companies and steady earnings in expanding markets. Prefers the shares of companies with predictable and stable sales, revenue and earnings.

Risk rating:

adventurous

screener:

next 20% of market ranked by 1-year volatility

market value greater than £10 million

exclude financials

BuyShares Moderate Portfolio members

BuyShares Moderate Portfolio – top 50 of 230 members

BuyShares Moderate Portfolio – Quality, momentum, value, growth scores:

Moderately aggressive stocks

Invests in large, mid-cap and small-cap stocks, with an objective of moderately above average long-term returns. Mid-cap tech and pharma stocks for capital appreciation with an element of safety from consumer non-cyclicals..

Risk rating:

speculative

Screener:

next lowest 25% of market ranked by 1-year volatility

market value greater than £10 million

excludes financials

BuyShares Moderately Aggressive Portfolio screen example

BuyShares Moderately Aggressive Portfolio screen Top 50 of 319 constituents

Aggressive stocks

Will include many growth stocks, many at the small-cap end of the spectrum. Higher proportion of higher risk speculative holdings. Focus on companies in fast-growing markets. These stocks have a tendecy to outperform in bull markets and underperform under bearish market conditions.

Risk rating:

highly speculative

Screener:

next lowest 30% of market ranked by 1-year volatility

market value greater than £10 million

excludes financials

BuyShares Aggressive Portfolio screen example

BuyShares Aggressive Portfolio top 50 of 205 constituents

BuyShares Aggressive Portfolio – Quality, momentum, value, growth scores:

How to use the risk-level buckets

An investor can either confine themselves to one bucket for their stock investments or introduce an element of diversification by holding in set proportions across the risk spectrum. For example a more cautious investor might invest 25% in conservative stocks, 25% in moderately conservative, 25% in moderate and 25% in moderately  aggressive.

What is of rebalancing and why is it important?

A portfolio has to be rebalanced as the valuation of the stocks held changes and the proportions in the overall portfolio move away from the risk bucket proportion allocated.

Where are stocks in the asset allocation pyramid?

A fully diversified investment portfolio should should not be confined to stocks from the risk buckets outlined above – other asset classes should be used to dampen volatility and risk. By spreading investments across a number of asset classes that have low return correlations to each other, stock investors further diversify to control risk.

Top of pyramid (high risk)

Penny stocks, alternative investments (including collectibles, crypto), leveraged derivatives

Mid-section of pyramid (medium risk)

Equities, equity mutual funds (plus investment trusts and ETFs that have an appropriate risk-return profile), property, high-yield bonds, debt

Base of pyramid (low risk)

Cash, bonds, commercial notes, debt

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