Investment Policy Controversy, Part 2

“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.

Ongoing Management

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.