December 13th 2024.
When it comes to investing, there are different strategies you can use to determine how much of your portfolio should be allocated to stocks versus bonds. One commonly used rule of thumb is the "60/40" rule, where 60% of your portfolio is invested in stocks and 40% in bonds. However, Nobel Laureate Robert Merton has developed a more precise formula known as the "Merton share" that calculates the optimal allocation to equities.
To use the Merton Share Estimator, you will need to input five key factors: the expected return of equities, the standard deviation of equities, the risk-free return, the standard deviation of risk-free investments, and the constant relative risk aversion. These inputs can usually be obtained from your financial services company, which also provides information on volatility (measured by standard deviation).
There are a few tips to keep in mind when using the Merton Share Estimator. First, if you have invested in multiple equity classes with different expected returns, such as US stocks and non-US stocks, you will need to calculate a weighted average return. Additionally, it is recommended to adjust for inflation and work with real returns, using Treasury Inflation Protected Securities rates as the risk-free return. Finally, you can use historical standard deviations for your calculations, but online tools like Portfolio Visualizer and the CBOE VIX index can provide more accurate data.
The Merton Share is calculated using a single formula, which divides the equity premium (the difference between equity return and risk-free return) by the squared standard deviation of equities. However, there are a few adjustments made by Professor Merton, such as dividing by the constant relative risk aversion instead of just the standard deviation. This allows for different levels of risk aversion, with a common range of constants being 1 to 5.
It's worth noting that someone who is risk neutral would have a constant relative risk aversion of 0 and would only focus on expected return rather than risk. Ultimately, the Merton Share Estimator suggests that individuals should bear more risk than they typically do in order to earn higher expected returns. It also suggests that diversifying beyond just US stocks is a smart way to reduce risk.
As you experiment with the Merton Share calculations and gather updated data on expected returns and standard deviations, you may find that your constant relative risk aversion input changes. This is something to be aware of, as it can impact your investment decisions.
If you're interested in learning more about the Merton Share and its applications, there are additional resources available including a companion calculator and Professor Merton's research paper. The team behind the book "The Missing Billionaires" also uses the Merton Share in their wealth advisory business and offers valuable insights on their website. Ultimately, the Merton Share is a useful tool for calculating the optimal allocation to equities based on your risk aversion and market conditions.
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