Low Risk Investors: Buy These 2 ETFs for an Ultra-Safe Investment Portfolio

A 60/40 balanced portfolio consisting of low volatility Canadian equity and money market ETFs is a good choice for risk-averse investors.

| More on:
edit Safe pig, protect money

Image source: Getty Images

Investors with a low risk tolerance, a shorter time horizon, or more modest investment objectives should favour preservation of capital over growth.

For these investors, the possibility of a market crash right before they retire can introduce sequence of return risk, potentially delaying retirement or crippling income potential. This must be taken into account when selecting an asset allocation.

Metrics like risk-adjusted returns, volatility, drawdowns, beta, and correlations all come into play. Picking and choosing asset classes that optimize this is critical to ensuring your investments succeed. Today, we’ll be going over construction of a balanced, minimal volatility portfolio suitable for low-risk investors.

What does low risk even mean, anyway?

The risk of our investment portfolio is measured with a few different metrics that all kind of work together to produce an overall risk profile.

First up is standard deviation. This is the percentage that your investments will fluctuate around their average return. For example, two separate portfolios both return 7% on average over 25 years, but the first has a standard deviation of 10% versus the second at 12%. The first portfolio will experience greater ups and downs, while the second will have a smoother ride.

The second is max drawdown and drawdown recovery time. This is a measure of the percentage our portfolio has historically declined from peak to bottom, and how long it took to get back to pre-crash levels. We want to keep drawdowns low and recovery time short, so our investments can get back to being profitable earlier.

Last is beta, a measure of how volatile a stock is compared to the market. The market has a beta of 1.00. A stock that swings more than the market has a beta that is greater than 1.00. A stock that moves less than the market has a beta less than 1.00. And stocks that move inversely to the market have a negative beta <0.00. We want to keep beta low, or even uncorrelated sometimes to reduce volatility.

How to construct a portfolio to mitigate these risks?

The lesson here is to keep the standard deviation, drawdown amount/time, and volatility of your portfolio low. Traditionally, this was accomplished by a balanced allocation of stocks combined with bonds via exchange-traded funds (ETFs).

For the stock allocation of your low-risk portfolio, I recommend BMO Low Volatility Canadian Equity ETF (TSX:ZLB). ZLB holds a portfolio of low-beta, blue-chip, large-cap stocks, and costs a management expense ratio (MER) of 0.35% to hold. The fund also has a annual yield of 2.36%.

The bond portion is more tricky. There is strong evidence out there to suggest that in today’s rising interest rate environment, bonds might not provide as much protection or gains.

Bond price are inversely relate to interest rates, with longer-duration bonds being more sensitive. In a rising rate environment, the negative correlation that bonds provided over the last three decades to help offset equity risk tends to fade, reducing their effectiveness as a hedge.

We need to seek alternatives here. My recommendation is a money market ETF like Purpose High Interest Savings ETF (TSX:PSA). PSA invests in high-interest savings accounts with Canadian banks and is as safe as it gets, with zero interest rate risk or default risk.

PSA does have a very low yield (0.81%) though, and may not outpace inflation. Still, it’s a marginally better solution than holding cash. We’re using PSA as ballast to smooth out fluctuations, and buy stocks cheap during a crash by rebalancing. The MER is 0.15%.

How has the portfolio performed?

A word of caution: the backtest results provide below are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Hypothetical returns do not reflect trading costs, transaction fees, or actual taxes due on investment returns.

From 2014 to present with all dividends reinvested, the Canadian 60/40 Low Volatility Balanced Portfolio performed exactly how we wanted it to.

Compared to the S&P/TSX Capped Composite Index, our portfolio had much lower standard deviation, drawdowns, and beta. The overall return was slightly lower, but the ride was much smoother, with a significantly better risk-adjusted return.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Tony Dong has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.

More on Stocks for Beginners

bulb idea thinking
Stocks for Beginners

2 No-Brainer Stocks to Buy With Less Than $1,000

There are some stocks that are risky to even consider, but not these two! Consider these stocks if you want…

Read more »

hot air balloon in a blue sky
Tech Stocks

3 TSX Stocks Still Soaring Higher With Zero Signs of Slowing

These three stocks may be soaring higher and higher, but don't let that keep you from investing – especially with…

Read more »

ETF stands for Exchange Traded Fund
Dividend Stocks

How to Use Your TFSA to Create $5,000 in Tax-Free Passive Income

Creating passive income doesn't have to be risky, and there's one ETF that could create substantial income over time.

Read more »

how to save money
Energy Stocks

This 7.8% Dividend Stock Pays Cash Every Month

This monthly dividend stock is an ideal option, with a strong base, growing operations, and a strong future outlook.

Read more »

Canada national flag waving in wind on clear day
Tech Stocks

Trump Trade: Canadian Stocks to Watch

With Trump returning to the presidency, there are some sectors that could boom in Canada, and others to watch. But…

Read more »

cloud computing
Dividend Stocks

Insurance Showdown: Better Buy, Great-West Life or Manulife Stock?

GWO stock and MFC stock are two of the top names in insurance, but which holds the better outlook?

Read more »

Man looks stunned about something
Dividend Stocks

Better Long-Term Buy: Dollarama Stock or Canadian Tire?

Both of these Canadian stocks have proven to be solid long-term buys, but which is better for the average investor?

Read more »

TFSA (Tax free savings account) acronym on wooden cubes on the background of stacks of coins
Dividend Stocks

How to Use Your TFSA to Earn Ultimate Passive Income

If you have a TFSA, then you have the key to creating ultimate passive income. All you need is a…

Read more »