Introduction
The safety-first rule is a principle of modern portfolio theory ( MPT), which believes the risk is an inherent part of reaping a higher reward level.
Safety first, in this case, means reducing the probability of negative returns. The rule proposes formulas that can be used by investors to create portfolios that optimize their expected returns based on a given level of market risk.
Understanding Safety-First Rule
The safety-first rule is to establish a minimum reasonable return or return threshold. By setting a target return, an investor seeks to reduce the risk of failing to achieve the return on investment. The safety-first rule, also known as Roy's Safety-First Criterion (SFRatio), is a quantitative investment technique in risk management.
Safety-First Portfolio
A simple formula for calculating the safety-first rule is
(Anticipated Portfolio Return - Portfolio Threshold Return) / Standard Portfolio Deviation
By using this formula along with various portfolio scenarios, such as using different investments or asset class weightings, an investor will compare portfolio choices based on the probability that their returns do not meet the minimum threshold.
A better portfolio in this situation will be the one that minimizes the likelihood of the returns of the portfolio falling below the threshold.
However, the safety-first rule is primarily a kind of philosophy or way to attain peace of mind. When an investor sets a minimum reasonable return for a portfolio, then he or she can rest assured knowing that there is a much lower risk of failing to achieve their target.
In other words, once the investor makes the portfolio "safe," any returns beyond the minimum return threshold realized is considered to be extra.
