“The key question is what asset allocation allows you to sleep at night.” Burton Malkiel.
An earlier post discussed the controversy related to the new Pension Benefit Guaranty Corporation’s (PBGC) Investment Policy. The relationship between Risk and Return were covered.
Discussing Risk and Return
When working with clients, I have them first complete an online Risk Tolerance Questionnaire, consisting of 25 questions. Their responses to those questions and the final score give me an indication of their experience and preferences in making investing decisions. The feedback from the questionnaire also acts as a basis for discussion of risks and returns and the inherent trade-offs.
Part of the process is to look at past returns for various portfolios. I typically go over returns from 1970 through 2007, because we have good data for various asset classes. I also like to emphasize the 13 “Bear” markets we have experienced since World War II.
What has happened in the past may or may not, necessarily, be indicative of future portfolio returns, so this approach is certainly not perfect. But in my opinion, looking at past performance history is the best we have to go by.
On the other hand, the Pension Benefit Guaranty Corporation’s (PBGC) consultant used estimated future returns to predict portfolio performance. Certainly a lot depends on the assumptions used, and some have rightly questioned those assumptions.
Determining Risk Tolerance
In his book The Only Guide To A Winning Investment Strategy You’ll Ever Need Larry Swedroe spells out the various issues in determining your risk tolerance.
The first step is to determine your willingness to accept risk. Do you have the discipline and courage to stick with an investment strategy when the going gets tough? Swedroe calls this the “stomach acid test.”
For example, suppose you decide on an aggressive portfolio, with a high percentage of stocks. Then a market decline causes your stomach to create excess acid, giving you agita, and causing you to lose sleep. If this chain of events results in your decision to sell your stocks or stock mutual funds, then you’ve overestimated your tolerance for risk.
Swedroe believes investors’ ability to take risk is “determined by three things: The investment horizon, the stability of their earned income, and the need for liquidity.”
The need to take risk is the final factor, “The need to take risk is determined by the rate of return required to achieve the investor’s financial objectives.”
Frankly, this last consideration – the need to take risk – seems to have greatly influenced the PBGC’s revised Investment Policy. They have a huge deficit. While an individual might simply decide to save a bit more or retire a little later, the PBGC’s situation is much more complicated.
Creating an Investment Policy Statement
Education, discussion, and introspection are all critical parts of the consultative process between me and a client. Finally, after much consideration, the client agrees on the basic asset allocation decision of their portfolio — how much should they invest in stocks and how much in fixed income or lower risk investments?
Once that decision is made, their job is over. Then it’s my task to come up with a globally diversified portfolio, representative of their allocation. I then present a “picture” of how this portfolio would have behaved in the past, ensuring that the client is aware that past performance is not an indicator of future performance, and we sign off on the agreement.
The final product is an Investment Policy Statement (IPS) which is a roadmap for the client and me, and which explains the expectations and responsibilities of each party.
Of course, designing the initial portfolio is merely a small part of the process. Asset location, monitoring the portfolio, periodic rebalancing and perhaps tax loss harvesting are other important parts of the process. So is revisiting the IPS when the client’s circumstances or goals change. And ongoing comprehensive financial planning is included for most clients.
Actually, follow-up is one area in which the PBGC has been criticized. In a later post, we’ll discuss the follow-up (or lack thereof) issue, PBGC’s more aggressive Investment Policy and whether this is appropriate for them.
“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?
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.