What is the Safety-First Rule
The safety-first rule is a tenet of modern portfolio theory (MPT), which believes that risk is an inherent part of reaping a higher level of reward. In this context, safety first means minimizing the probability of negative returns. The rule suggests formulae that investors can use to construct portfolios that will maximize their expected returns based on a given level of market risk.
Breaking Down the Safety-First Rule
The safety-first rule involves creating a minimum acceptable return, or threshold return. By fixing a threshold return, an investor aims to reduce the risk of not achieving the investment return. The safety-first rule, also called Roy's safety-first criterion (SFRatio), is a quantitative risk-management investment technique.
Constructing a Safety-First Portfolio
A basic formula for calculating the safety-first rule is (expected return for portfolio minus threshold return for portfolio) divided by standard deviation for portfolio. By using this formula along with various portfolio scenarios — that is, using different investments or different weightings of asset classes — an investor may compare portfolio choices based on the probability that their returns will not meet the minimum threshold. In this case, the best portfolio would be the one that minimizes the chances that the portfolio's return will fall below the threshold.
More than just a formula, however, the safety-first rule is primarily a kind of philosophy, or way to achieve peace of mind. When an investor sets a minimum acceptable return for a portfolio, then he or she may rest easy, knowing that the risk of not achieving her goal is much lower. In other words, the investor first makes the portfolio “safe,” then any return above the minimum-return threshold that she realizes is considered extra.