What is Roy's Safety-First Rule?
Roy's safety-first rule is a measure of the minimum returns an investor requires from a portfolio. The formula for Roy's safety-first rule is:
Roy's Safety-First Rule = (Expected return for portfolio – Threshold return for portfolio)/Standard deviation of portfolio
How Does Roy's Safety-First Rule Work?
The mechanics of the formula are simple: Input the investor's minimum required return, the expected return for the portfolio, and the standard deviation for the portfolio. By using this formula for various portfolio scenarios (i.e., using different investments, using different weightings of asset classes), investors compare portfolio choices based on the probability that their returns will not meet the minimum threshold. The best portfolio is the one that minimizes the chances that the portfolio's return will fall below the threshold.
Why Does Roy's Safety-First Rule Matter?
The safety-first rule is much more than a formula. It is a philosophy. By setting a minimum acceptable return for a portfolio, the investor is able to sleep at night because he or she knows that the risk of not achieving their goals is much lower. The investor first makes the portfolio 'safe,' and anything above that minimum threshold is gravy.