Investing Is About Choosing Which Risks You Take, Not Avoiding Risk

In my role as a consultant to financial advisors, I have been getting a lot of requests asking for help in addressing investor concerns about the elevated economic cycle risks, stretched equity levels, rising geopolitical risks, mounting government deficits and debt levels. This article lays out the framework for advisor/client discussions, helping investors understand the risks they are taking with traditional portfolios and the tradeoffs involved in diversifying into alternative assets.

Unfortunately, most investors don’t think of portfolio construction as a series of choices about which risks to bear. They think of it as a search for the “right” allocation — as if there’s a formula that produces the correct answer for everyone. There isn’t. There’s only a menu of risks, each with an associated risk premium, and a decision about which of those risks you’re willing to live with.

That framing matters more than usual right now.

The Comfortable Portfolio Isn’t Comfortable Anymore

The traditional 60/40 portfolio — built from total stock market and total bond market index funds — has real virtues. It’s cheap. It’s simple. It generates no tracking-error anxiety for the investor and no business risk for the advisor. Since a portfolio that looks like the market is, almost by definition, defensible: advisors rarely get fired for owning the market.

But the 60/40 portfolio has a structural feature that’s easy to overlook: because stocks are so much more volatile than bonds, the equity risk in a 60/40 portfolio is not 60% — it’s roughly 85-90%. As a result, equities contribute the overwhelming share of total portfolio volatility. And both stocks and bonds, despite their different volatility profiles, share a common vulnerability: they’re both heavily exposed to the same underlying macro forces — economic cycle risk and inflation risk. When growth disappoints or inflation surprises to the upside, stocks and bonds can, and increasingly have, sold off together (as they did in 1931, 1969 and most recently in 2022).

That’s a fine trade-off if you’re not worried about the economic and geopolitical backdrop. It’s a much less comfortable one if you are.

Why the Worry Is Showing Up Now

A growing number of investors and advisors are, in fact, worried. Geopolitical tensions are elevated and multipolar in a way they haven’t been in decades. And beneath the headlines sits a slower-moving, but arguably more consequential problem: government deficits have become a near-universal feature of the developed world, not just a U.S.-specific one. As debt loads climb and interest rates have risen, interest expense is consuming a rising share of government budgets across most developed economies simultaneously. For example, here’s one data point that should give everyone at least some concern: government interest expense as a share of government revenue for the United States is currently estimated to be 18.6% in 2026. That is higher than Greece’s 17.8% ratio during their financial crisis of 2011. (However, Greece’s debt-to-GDP ratio was about 171%, with the U.S.’s being just over 100%.)

That combination — heavy debt loads plus persistently higher rates — creates a narrowing set of paths forward, and not all of them are benign. Governments facing mounting interest costs have historically had three levers: raise taxes, cut spending, or inflate the debt away. All three are politically fraught, but the third is the path of least immediate resistance — exactly why investors worry about it.

There’s a mechanism here worth spelling out, one that economist John Cochrane has developed: “the fiscal theory of the price level.” The idea is that when investors begin to doubt a government’s ability or willingness to service its debt, they demand a higher risk premium to hold that debt. That higher premium raises real interest rates, which raises the government’s borrowing costs — which in turn makes the debt harder to service, reinforcing the original doubt. It’s a vicious circle. And the same higher rates that raise the cost of debt also slow economic growth (as government debt crowds out private investment) which shrinks the denominator in the debt-to-GDP ratio at the same time the numerator is growing. The result can be a self-reinforcing dynamic in which concern about debt sustainability itself makes debt less sustainable — independent of any single policy misstep.

It’s important to note that the combination of weak growth and higher inflation is precisely the environment in which both stocks and bonds tend to struggle at the same time. It’s also the environment a 85-90%-economic-cycle-risk portfolio is least equipped to handle.

The Actual Choice Investors Face

If you want or need higher returns than you can earn on riskless one-month Treasury bills, there is no risk-free choice. Thus, if an investor is genuinely concerned about geopolitical shocks and economic-cycle risk, one option is simply to reduce exposure: hold more Treasury bills or other high-quality short-duration instruments, accept a lower expected return, and reduce the portfolio’s sensitivity to risky assets. That can be a perfectly rational response for a sufficiently risk-averse investor.

For investors who desire or need a higher return than available on one-month Treasuries, they cannot opt out of risk; they can only choose which risks they carry and in what proportion. This means not abandoning risk assets altogether: Instead, it involves diversifying into return sources whose primary drivers differ from public-equity beta and conventional duration (inflation) exposure. Examples include:

• Reinsurance. The intended source of return is compensation for bearing insured catastrophe risk, such as hurricanes or earthquakes. These risks have essentially no relationship to GDP growth, interest rates, or equity markets. However, investors should recognize that collateral values, underwriting cycles, manager skill, diversification, and event clustering (tail risk) can matter materially.

· Market-neutral or long-short factor strategies. By seeking to hedge market beta, these strategies aim to isolate factor premiums such as value, momentum, and quality or profitability. Importantly, each of these factors themselves have low correlation with each other. Their outcomes nevertheless depend on model design, implementation, financing, crowding, and manager execution.

• Senior secured private credit (PE sponsored, floating rate). Seniority, collateral, and floating coupons reduce duration, and thus inflation, exposure, but they do not eliminate credit-cycle risk, underwriting risk, default risk, or liquidity risk.

• Private infrastructure. Assets like regulated utilities, toll roads, and contracted power generation, often with revenues explicitly linked to inflation, are structurally less exposed to short-term growth swings. Regulatory, political, operating, financing, and valuation risks remain important.

• Private real estate. Property cash flows may benefit from leases and long-lived assets, but real estate can remain economically sensitive—particularly through occupancy, rents, refinancing conditions, and capitalization rates. It’s also important to keep in mind that while the correlation to equity is sufficiently low to provide diversification benefits, the reported volatility of the asset class is understated due to stale pricing based on appraisals.

None of these exposures is a free lunch. Each carries its own idiosyncratic risks: underwriting risk in reinsurance; model, execution, and crowding risk in factor strategies; credit-selection and liquidity risk in private lending; regulatory and operating risk in infrastructure; and property-market, financing, and valuation risk in real estate.

That is the central point. The objective is not to eliminate risk. It is to substitute, diversify, and size risks so that the portfolio is less concentrated in the specific risks an investor most wants to reduce.

The Real Trade-Off

The cost of building this kind of portfolio isn’t hidden, and it isn’t small. It shows up in three places:

Liquidity. Reinsurance funds, private credit, and private infrastructure are not daily-liquid. Capital can be locked up for years. That’s a real constraint. It means these allocations have to be sized against an investor’s actual liquidity needs, not just their risk tolerance.

Complexity. These are not index funds. Manager selection matters enormously, due diligence is harder, and the strategies themselves take more explaining — both to clients and to yourself when performance inevitably diverges from the S&P 500 in some quarter.

Tracking-variance risk. This is the one I’d underline for advisors, because it’s purely behavioral rather than financial. A portfolio that doesn’t move in lockstep with the market will, at some point, underperform it — sometimes for a stretch of years. That’s uncomfortable. It invites second-guessing from clients, and it invites the business risk advisors are naturally trying to avoid by hugging the benchmark in the first place. But avoiding tracking-variance risk isn’t costless either — it just means accepting full exposure to whatever the market throws at you, geopolitical and fiscal risks included.

So, the choice, laid out plainly, is this: you can hold the risks you’re worried about and try to live with them (or retreat to T-bills and give up expected return), or you can accept less liquidity, more complexity, and somewhat higher costs in exchange for a portfolio that’s genuinely less exposed to the specific risks keeping you up at night. There’s no version of this where you get diversification against economic-cycle and inflation risk for free.

This Isn’t a New Idea — It’s an Institutional One

This approach to portfolio construction isn’t speculative. It’s how the largest, most sophisticated institutional pools of capital — the Yale and Harvard endowment models, among others — have built portfolios for decades: identifying which risks are being compensated, deliberately taking the ones with the most attractive premiums and the least overlap with each other, and accepting illiquidity and complexity as the price of that diversification.

What’s changed is that this approach is no longer available only to endowments with multi-decade time horizons and no daily redemption pressure. A widening set of vehicles now gives individual investors and their advisors access to reinsurance, long-short factor strategies, senior secured private credit, and private infrastructure — in structures built for the liquidity and reporting realities of a taxable individual or a RIA’s book of business.

It is important to note that institutional success should not be treated as automatic evidence that a strategy is suitable for every individual investor. Institutions may have longer time horizons, access to differentiated managers, and greater capacity to withstand illiquidity. Thus, the relevant questions are whether the investor understands the exposure, can tolerate the liquidity and valuation characteristics, and is being adequately compensated for the risks and fees involved.

My Portfolio

Being concerned about the elevated economic and geopolitical risks, I address that concern by diversifying across many different unique risks. (Note: the following list is not a set of recommendations. They are choices tailored to my personal ability, willingness and need to take risk, my ability to accept tracking variance risk, my personal due diligence, and tailored to my personal goals and objectives). The most significant of the allocations are:

AQR Long/Short Funds: QSPRX, QRPRX, a separately managed account, and a private partnership (14%)

Reinsurance: SRRIX and XILSX (14%)

Private Credit: CCLFX, CELFX, and FRBBX (9%)

Non-Traded Private Real Estate: BREIT and JPM REIT (10%)

Infrastructure: XHIYX (6%)

These five asset classes total about 53% of my portfolio. I have some additional small exposures to other private investments including to energy and drug royalties. Thus, my total allocation to these alternatives is about 55%. The remainder is allocated to public equity (25%), private equity (11%), and money market accounts (no traditional bonds). [Note that while private equity is considered by many to be an alternative asset class, because it has the same exposure to economic cycle and geopolitical risk as public equity I do not consider it to be a true alternative and its allocation should be considered part of the equity allocation.]

I accept the conditional liquidity of the reinsurance, private credit, private real estate, and infrastructure (while earning a significant illiquidity premium) as I don’t need all my portfolio assets to be daily liquid (and I can redeem a minimum of 20% a year of each of them, which is far more than my annual spending) and the tracking variance risk created by the diversification (my returns will look nothing like the returns of the market). With that said, I don’t care about what the equity market returns. What I care about is reducing exposures to the economic and geopolitical risks that create the left tail risk inherent in traditional portfolios. And my allocations accomplish that objective. Importantly, adding the higher yielding alternatives assets that have low correlation to economic cycle and inflation risks means that I can hold a much lower percentage of traditional bonds (with significantly lower expected returns) which are typically used to reduce the tail risks of equities (but the risks can show up at the same time as they did in 2022).

The Bottom Line

There is no portfolio that eliminates risk — only portfolios that allocate it differently. If you’re comfortable with the economic-cycle and inflation risk embedded in a traditional 60/40 portfolio, there’s nothing wrong with holding it: it’s cheap, simple, and transparent. But if economic, geopolitical, and fiscal risks are genuinely costing you sleep, the honest alternatives are to reduce risk outright by holding more T-bills, or to diversify into risk premiums that don’t share the same macro DNA as stocks and bonds. Either path involves a trade-off. The only mistake is pretending there’s a way to avoid making one.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest Enrich Your Future. He is also a consultant to RIAs as an educator on investment strategies. He has spent decades helping advisors and investors apply the evidence from academic finance to real-world portfolios. This article is for informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice.