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The risk-return tradeoff: What’s the right asset mix for a 5% return?

Most investors spend much more time assessing, calculating, comparing and pursuing returns than they do considering the other side of this same coin: the risks taken to achieve that return. However, in the current market conditions, investors – and particularly conservative investors - should consider the inevitable tradeoffs they are making when seeking to maintain certain levels of income.

This article explores two simple questions:

  1. How should you invest to earn a 5% per annum return with the least risk?
  2. Has the optimal mix changed over time?

To spoil the fun a little, the answer to Question 2 is yes. Optimal portfolio allocations have shifted considerably, but in essence, have done so due to the gradual but consistent fall in market interest rates.

This is important because, in addition to indicating the return available from cash and bonds, interest rates are also used to value cashflow producing assets such as shares, property and infrastructure. As the interest rate falls, the value of future cashflow rises.

Chart 1: Australian 5-year government bond yield

Source: Bloomberg

While interest rates are a key driver, there are other important factors. The outcomes of an investment in a term deposit or government bond are predictable, but the future cashflows of a company or the prospects for an investment property can shift quickly.

The most common measure to represent this risk is volatility, but many investors find this statistical measure difficult to bring to life. Instead, for this article, we will represent risk in terms of the likelihood of a negative return over a 10-year period.

Table 1: Asset Class Risk Assumptions

Source: RBA, ICE, Corelogic, Bloomberg

With the data and assumptions from Chart 1 and Table 1, we can now answer the first of our introductory questions.

How have portfolios changed over time to achieve 5%? 

Chart 2 provides some important information on the ‘5%’ portfolio.

First, there is a strong correlation between market interest rates and the composition of the portfolio. Second, our investor seeking 5% per annum is forced to take more risk to achieve the stated aim as the market interest rate has fallen over time.

Chart 2: Optimal portfolios to achieve at least 5% per annum (risk-adjusted)

Source: Bloomberg, Corelogic, Daintree

In contrast to the turmoil of the 1987 stock market crash and the ensuing recession, financial markets of the mid-to-late 1990s were characterised by a general sense of calm. The RBA cash rate started the decade at 14-15%, but by January 1995 had fallen to 7.5%, with a 6-month deposit rate of 9.15% pa. This easily exceeds our requirements and the risk involved in earning that return would be very low.

By January 2000, interest rates had continued to ease, with the same 6-month deposit rate falling to 5.99%, still sufficient to meet our criteria. However, the yields on offer from fixed income were higher than those for deposits, and after accounting for the risk involved in a broad-based fixed income exposure, the optimal portfolio includes a small weighting to fixed income.

While cash rates were relatively stable through January 2005, the future returns available from credit fell considerably as longer-term interest rates fell. This drove solid returns from our small exposure to fixed income, but our investor was now faced with reinvestment risk. Therefore, in 2005 we could revert to bank deposits to achieve our goal, at the expense of potential further upside in asset values.

The following five years were eventful, to say the least, as the GFC created significant turmoil across the board. By now, our investor was being forced to deviate significantly from cash to attain their return target, with a significantly higher allocation to fixed income, property and equities, despite the lingering volatility.

By 2015 and continuing through 2020, apart from a nominal exposure to cash and fixed income, our investor had come to rely on growth assets such as shares and property to provide their return. Using our assumptions in Table 1 for the gross income return from a property or share portfolio, there is still some reliance on capital growth needed to achieve our goal.

Are there other options?

The analysis so far should make for uncomfortable reading for conservative investors. The prospect of cash or deposit rates rising to anywhere near 5% in a reasonable timeframe is remote.

In January 2021, the yield on a 6-month deposit ranges between only 0.3-0.6% pa. A broad fixed income index is offering 0.8-0.9% pa. The ASX 200 gross dividend yield is 3.6% pa, and the average gross yield from residential investment property is currently about 4% pa.

So apart from relying on capital growth or using leverage, no combination of these broad asset classes will achieve a 5% income return. Furthermore, interest rates cannot go much lower, removing one of the more reliable tailwinds for asset prices.

One asset class has not been included so far may improve overall outcomes by offering a predominantly income return at a manageable level of risk. Despite being a relatively ‘young’ asset class, hybrid securities are designed to have fixed income and equity characteristics. Specifically, income is paid periodically and there are defined call dates like many fixed income securities, while in certain circumstances hybrids can be converted to equity of the underlying issuer.

Importantly, observed volatility over time has tended to be a fraction of that of equities. On average, hybrid securities will register a negative return over a calendar year once every seven years. This equates to about one-third of the volatility experienced in equity markets.

In Australia, we have only seen three calendar years where hybrid returns were negative since the turn of the century, but on two of those occasions the maximum drawdown was less than 3%. Average returns, inclusive of franking, over this same period were approximately 6.5% pa.

With the inclusion of this additional data, optimal portfolio allocations would change to include hybrids in most time periods.

Chart 3: Optimal allocations including hybrids (risk-adjusted)

Source: Bloomberg, Corelogic, Daintree

Hybrid securities have been a part of Daintree Capital’s process for some time. We have identified the attractive return and risk characteristics of this asset class and have included them in our High-Income Trust since its inception in November 2018.

Implications for investors

The monumental changes in interest rates have forced all investors to revisit many fundamental assumptions about risk and return. The seemingly unstoppable trend of falling interest rates has changed the game when it comes asset allocation and the role of different types of assets within portfolios. While we do not expect a reversal of these trends anytime soon, the zero lower bound presents a formidable barrier.

Conservative investors are now forced to choose between:

  1. protecting capital in exchange for lower income;
  2. drawing down capital over time to maintain a certain living standard; or
  3. taking additional risk in search of higher yields.

Our analysis shows that when it comes to the third option, the amount of additional risk that must be taken is rising over time. Therefore, we believe it is becoming increasingly important to prioritise risk management as part of the portfolio construction process.


Brad Dunn is a Senior Credit Analyst at Daintree Capital. This article contains general information only as it does not take into account the objectives, financial situation or needs of any particular person. The article is intended to illuminate broad market trends and should not be treated as an exhaustive analysis of the topic.


Ramon Vasquez
May 21, 2021

Hello .
Does anyone remember a supposedly genuine experiment was conducted in Sweden whereby a chimpanzee threw darts at an open page of a newspaper's list of stocks ?
Supposedly , the chimp's performance was NOT less than in any fund manager 's performance !

Take it easy , Ramon .

April 21, 2021

This comment is no longer available.

SMSF Trustee
April 22, 2021

Bluey, you're still out of line. I am simply saying that there's more risk in your strategy than you think. I'm not an advisor so I'm not telling anyone that the way I invest is how they should, but I remain offended by you linking me with those spurious names. Here's my strategy: - some direct shares, but no more than 10% of my portfolio - some managed Australian share funds with a couple of the top managers in the country (and which provides just as much liquidity as direct shares) - some diversified global credit and high yield funds that are managed by some of the best known names in the world - some global shares with an index provider and a very well known Australian manager of international equities - cash equivalent to a couple of years of income that I want to protect for when I do retire in a couple of years' time That is also a simple, tried and tested approach that has served me very well as I build my super towards my retirement. And it is not susceptible to one company going the tube before I have a chance to exit the holding, which is the risk that you're taking. And it's not with rogues, but well established companies who are regulated by ASIC and operate very open businesses that anyone can peer into. And you want a couple of Australian names that are faded blue chips - AMP, Adelaide Steamship and Pasminco come to mind. It can happen here. But come on, mate, defend your beliefs by all means, but stop with the unfounded insults.

April 22, 2021

I heard you first time. You are not an advisor yet you are keen to tell 'Enrico', 'James' and myself how risky is their strategy . You tell us you invest in some Aus Managed Share funds [eg. Colonial]; what equities do they hold predominantly? Well I looked up a few on their website and guess what, I saw quite a lot of blue chips such as CBA, CSL, BHP, NAB, MQG, TLS etc. I guess they have to be unless they think they can beat the index every year with something else. The difference is that you and any spruikees pay fees, whilst we don't, and frankly I'd rather avoid the reverse compounding effect of fees for 20yrs than worry about the ever present, but rare as martians risk that all 15 stocks cancel their dividend payment, or on of them suddenly vanish into a sinkhole. Don't forget to read Peter Thornhill's article [referenced this week], a hero of mine, he would appear to have 40yrs experience of studying the Aussie market, to trump my 20.

April 21, 2021

I find all the comments on this article more interesting and informative than the article itself. Thank you. I have also achieved a minimum and sustained 5% income yield by investing in 20 dividend producing shares/ETFs/hybrids/funds. I chose 20 so that I spread the risk. Top performers this year have been BHP, DDR, DTL, MQG and VDHG. Duds have been WPL, FLT and AGL. Hopefully WBC will give us all a nice catch up dividend in June.

April 19, 2021

Excellent discussion piece thanks Brad. We certainly live in interesting times and the job of an investment adviser has never been more challenging (or interesting) than this period in history.

April 18, 2021

Thankyou James. Holding a selection of blue chip shares [e.g. from the ASX20] easily targets a 5% gross return from dividends. Holding just one years cash may be enough; even with this shocking global pandemic the drop in dividend payout over the 12months is still less than 50%. As Enrico says, the capital value may fluctuate but should not be of much concern [unless a particular stock loses relevance, in which case you need to get out]. Of course, this strategy is too simplistic for the financial services salesmen, they'll tell you it needs to be more complicated [to justify their involvement, existence, fees].

SMSF Trustee
April 19, 2021

No, Bluey, it's not just simplistic, it's risky. And I say this, not from the point of view of a 'financial services salesman' but as someone who has his and his wife's SMSF to look after. I wouldn't be caught dead with only a handful of blue chips and some cash to rely on!
If I were to have just Australian equities and cash, I'd at least have one quality active manager to do the rotation away from declining blue chips for me and to invest a small portion into emerging stocks. (One of the managers I use has shot the lights out in the last couple of years because of a stock I'd not have thought of owning, Afterpay.)
And besides, you don't need to have just cash for the couple of years of living expenses - a good, low duration corporate bond fund can play part of that role and earn better income than cash or term deposits, as has been my experience in my SMSF.

April 20, 2021

"..declining blue chips.."??
F.Y.I. I have held BHP, CBA, CSL, RIO, WES [>COL], NAB, ANZ, TLS, ASX, WOW, WPL, MQG for 20-21yrs. None have gone broke yet. Most pay good dividends [not a handful, a sackful], the others offer growth. It doesn't shoot the lights out like a portfolio of tech stocks, but I've had a more than 5% yield for 20yrs, quietly compounding [reinvested into whatever is not the flavour of the day]. And if and when one of them does become irrelevant, I am watching and will sell. Eventually when I retire, will I be saying wow that was so risky? Only if I was putting large amounts into stocks like Afterpay. Australia's biggest companies may not be well diversified, but they work for a compounding portfolio. In my view the risk is way less than having your savings managed by someone like Bernie Madoff, Mayfair 101, Melissa Caddick, David Hunter Campbell, Ross Hopkins, Pullen Pillay, Latrobe, Morgans, Storm Financial, Steve Halgrin, Peter Foster, Halifax Investment, Ross Tarrant [Trio], Graeme Hoy, Roger Munro, Yossi Herzog, Rollo Sherriff, Melinda Scott, Stefan He Qin, Mervyn Tarrant, Bob Blanchard, Jeffrey Meads, BRG, Sonray Capital, Opes Prime, Tricom, Dixon Advisory, Gabriel Nakhl, Antonio Pisano, Ng You Zhi, MFGlobal, Sonray Capital, MFS. I could go on, but you get the picture, it's not just the odd bad apple. This is risk; keep it simple.

SMSF Trustee
April 21, 2021


I wouldn't use any of those folks either, whether on reputation grounds or for the simple fact that most of them recommended highly concentrated investment portfolios like yours! So please don't infer that I'm suggesting something dangerous - the exact opposite.

Instead of holding a dozen stocks directly, a mainstream fund manager like Colonial, Ausbil, Pendal etc will get you the dividend income and franking you want, but in a more diversified equity portfolio that is doing thorough, up-to-date research.

And just because the stocks you hold have not gone broke yet, doesn't mean they can't or won't. General Motors was a blue chip in the US for years, but went broke; Northern Rock was a blue chip financial institution in the UK, but went broke; Washington Mutual was a blue chip American bank that went broke; Merrill Lynch didn't go broke, but got taken over by Bank of America at much reduced price for shareholders.

Not all of these could be watched and simply exited - there were either rapid developments that tipped them over the edge, or there were always management stories about new strategies that would turn things around to keep investors in.

EG from your list - Telstra, is trading at its lowest price in years and well below where it's been for much of its private life. How confident can you be that it isn't going to have to reflect its financial reality in a severe cut in dividends and potentially worse?

Please, don't be naive about these things!

But above all, don't put words in my mouth by presuming that I'm spruiking nonsense like the examples you gave. I manage my own SMSF using reputable managed funds in a diversified portfolio of shares, corporate bonds, high yield and property. I'm speaking to you as someone who genuinely cares that folk don't get caught by the Mayfairs and Melissa Caddicks of the world. You're not in that situation, but you do have a high risk portfolio in other ways.

April 18, 2021

I can't pretend to be anywhere near as sophisticated an investor as those who post here so I've kept it pretty simple.
I bought blue chips when the price dropped to the point the dividend paid at least 5% which gives me 6.5% with franking.
Having achieved this, I don't care what happens to the share price; I've locked in my dividend. If the share price falls I'll only make a loss if I sell and I don't intend to do this lightly.

I have about two years living expenses in cash and am eligible for a small Centrelink pension.
Under the assets test, when I spend some of the cash the pension increases by 7.5% of the amount my assets have reduced.

I saved and went without all my working life and now feel totally relaxed about spending to enjoy my retirement.

SMSF Trustee
April 18, 2021

Except you haven't locked in that dividend. There is still plenty of risk as was proven last year when dividends fell sharply and are still only just recovering.
You're right that share price volatility is just something to live with, especially since you've got those 2 years of living expenses in cash which creates a buffer. But if the companies you own go down the tube at some point - which is possible, that's the nature of equity markets, even for blue chips - then you also face permanent capital loss risk.
Your strategy is higher risk than you think.
And what do you mean that you 'went without' all your working life? Putting a bit aside for your retirement is a sacrifice, yes, and it might mean you didn't take the overseas trips that others did, but please don't exaggerate. I doubt you'd be as relaxed about life now if you had genuinely 'gone without' all those years.

April 18, 2021

I'm happy to draw down on capital to meet my living expenses if needs be. That's what it's there for imo. I'm more comfortable doing that than going too far up the risk spectrum.

April 18, 2021

A little critical, but a spruik about your fund that includes Hybrids, without actually saying what Hybrids are is inlikely to attract business. Anyone who knows, has already considered them, and probably your fund.

SMSF Trustee
April 18, 2021

Neil, Brad says in the article : hybrid securities are designed to have fixed income and equity characteristics. Specifically, income is paid periodically and there are defined call dates like many fixed income securities, while in certain circumstances hybrids can be converted to equity of the underlying issuer."

What more are you looking for?

KIm Wilkinson
April 15, 2021

Where are "bonds" in this analysis?

Brad Dunn
April 16, 2021

Hi Kim,

Bonds are captured under the "Fixed Income" heading. We deliberately chose a very broad index that included sovereign bonds, corporate bonds and securitised assets to proxy this asset class.

April 15, 2021

"Conservative investors are now forced to choose between:
* protecting capital in exchange for lower income;
* drawing down capital over time to maintain a certain living standard; or
* taking additional risk in search of higher yields.":

It is possible to 'walk a line' twixt those:

= RATE(30, 0.04, -1, 0, 0
= 1.219% (real)

* assume fund to be completely drawn down over a long enough time to be considered a success, (after death).
* reduce withdrawals as a portion of initial capital by a smidgeon.
* reduce risk (volatility) to a fraction of return.

April 15, 2021

James - yep, agree, but you to have the discipline and ability to sleep soundly at night to maintain that strategy ! I'd suggest anyone interested should look up Peter Thornhill's articles on FirstLinks (search under author) as this is broadly his approach and it's discussed in depth in the FirstLinks articles he has penned (and their associated comments)

April 15, 2021

Simple. Predominantly equities and keep 3 years worth of living expenses in cash, to avoid being a forced seller in a market downturn!

SMSF Trustee
April 15, 2021

Actually James, what you're suggesting is answering a completely different question. The article is explicitly about how do you target a 5% return. It's not about how to generate the maximum return subject to a cash flow constraint, which is what you're talking about.

But your suggestion doesn't answer that question very well either, frankly. It's just too simplistic and only provides a potentially helpful answer for a small number of investors.

For one thing, what total percentage of the portfolio does '3 years worth of living expenses' represent? If that is 50% of the investor's funds, then having a 50/50 cash and equity portfolio might not only fall short of generating 5% per annum (cash at less than 1% on half needs equities to generate 9-10% a year, which is far from guaranteed).

Brad's analysis highlights that achieving a given return target requires more risk to be taken. It proposes a way to extend risk, but in a diversified way that helps to manage the risk well. It deserves much better responses than simplistic rules like the one you've put forward.

April 17, 2021

I like to keep it simple. I’ve mainly LIC’s that consistently pay fully franked dividends that easily achieve at least a 5% return, some ETFs and quite a bit of Vanguard Conservative Index Fund that strangely enough consistency delivers at least 5%. Coupled with a few broad international funds that consistently do north of 10%.

I concede that one probably needs quite a bit of wealth for this to work (3 years in cash), however that depends how expensive one’s lifestyle is!

As an aside, I seem to recall Noel Whittaker recommending holding about 3 years worth of living expenses aside too.


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