What it is:
The safety-first rule, also called Roy's safety-first rule, is a measure of the minimum returns an investor requires from a portfolio. The formula for the safety-first rule is:
Safety-First Rule = (Expected return for portfolio – Threshold return for portfolio)/Standard deviation of portfolio
How it works (Example):
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 or using different weightings of classes), investors compare portfolio choices based on the probability that their returns not meet the minimum threshold. The best portfolio is the one that minimizes the chances that the portfolio's return fall below the threshold.
Why it Matters:
The safety-first rule is 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 a goal is much lower. The investor first makes the portfolio "safe," and anything above that minimum threshold is gravy.