Investment Policy Controversy, Part 1

“To get one thing that we like, we usually have to give up another thing that we like. Making decisions requires trading off one goal against another.” – Gregory Mankiw.

A recent New York Times article by Floyd Norris about the Pension Benefit Guaranty Corporation’s (PBGC) revised investment policy goes in depth into a controversy – how can they increase expected returns and at the same time lower risk? The discussion is relevant to individual investors.

The old PBGC policy called for an allocation of 25% in equities and 75% in U.S. Treasury bonds, an allocation typical of an insurance company. The PBGC’s report specifically recognizes that there has been an “opportunity cost” in being too conservative, which is why they have revisited their strategy. Their new allocation will be 45% equities, 45% bonds and 10% “alternative investments” meaning private equity funds and real estate (but not commodity funds or hedge funds). This approach is much more in line with what a typical individual investor or pension plan might use.

The controversy is that they claim that they will both increase expected returns and lower risk at the same time. Some disagree with this assessment and also whether the new approach is appropriate for an entity that insures failed pension plans.

We will cover the controversy in a later post. For now, let’s see how the issues apply to you.

Return and Risk

To earn higher returns, you must take on the risk of ownership of companies and real estate. Safer investments have lower expected returns. The typical tradeoff is between equities (stocks) and fixed income (bonds and cash equivalents). The higher proportion of stocks you have in a portfolio, the higher your expected return. (Note the word expected.)

But the larger percentage of stocks, the more your portfolio will fluctuate. And if we ever have another Great Depression, you can be sure that stocks will have very bad results. So if you want safety, put your money in insured CDs or U.S. Treasury securities. But realize that your returns will be low, possibly negative after taxes and inflation. If you hope to get higher returns than inflation, you have to invest some money in stocks and accept the possibility of being disappointed.

Just as the PBGC did, when deciding on an investment strategy, you must determine how much risk you should take. Considerations include individual circumstances, the willingness, ability, and need to accept short-term fluctuations to achieve better long term results. But what do we mean by risk?

Measuring Risk

One way investors view risk is the chance they might lose money. This is certainly valid for an individual stock. But what about an entire portfolio?

For a collection of investments, one accepted way to measure risk is the standard deviation of the portfolio. Standard deviation can be thought of as the volatility of a portfolio, how much it fluctuates. In general, a portfolio will fluctuate less if the components do not move together, and therefore risk (as defined) is lower. This is why proper diversification is so important.

Having many Large Cap Growth Stocks will not yield proper diversification, but adding other asset classes that are not correlated with Large Cap Growth Stocks will. Certainly fixed income investments reduce a portfolio’s expected volatility, especially U.S. Treasury bonds or Treasury Inflation-Protected Securities.

Another example is Real Estate Investment Trusts, and some advisors believe commodities offer diversification benefit. Strangely enough, a small amount of Emerging Market stocks could lower portfolio volatility, even though Emerging Market stocks are themselves quite volatile. It all depends on the correlation between an added asset and the existing portfolio.

Another Definition of Risk

Standard deviation is one definition of risk, but there are others. It is not an easy task to capture so much in one concept or number. The world is uncertain and therefore so are future returns of various investments.

Not meeting a goal is another important definition of risk. For the PBGC that means not having enough assets to meet its benefit obligations. For you it might mean not having enough assets to fund your retirement living expenses. Perhaps your individual situation is such that you will have to shoulder risk (short term volatility) in order to have enough money to retire in 20 years. Playing it safe will just not do for you. So as with many financial planning issues, it depends on your individual circumstances.

How this get applied is discussed in the next post.