With interest rates and returns on “safe money” at or near record lows, most people understand that you need to take some investment risk with your portfolio to generate meaningful returns – especially once you take inflation into account.
After all, if returns on risk-free CDs or money market funds are around 2 percent, but inflation is at 3 percent, then money you put in these products simply guarantee that they will steadily lose real value over time.
But most other investment vehicles have at least some potential for loss. An uncertainty of future returns, which we call “risk.”
The process by which we manage risk exposure to keep portfolio uncertainty to manageable levels while still offering a reasonable return on money is called “risk budgeting.”
The math can be relatively complex, but here’s how it works:
Step 1: Determine your risk tolerance. Your advisor, agent or other financial professional, ideally, will have a detailed conversation with you about the level of uncertainty you can tolerate. For example: Suppose the stock market fell 10 percent in a week, or 20 percent in a month. Would you A.) Want to sell all your assets and put them into something safe right away? B.) Stay put and watch what happens, or C.) Invest more, at bargain prices.
If you picked C, you may be a more aggressive investor, with a higher risk tolerance. But this is just one way of looking at the question.
A financial professional may also ask you to list your goals, and look at the amount of time you have to reach them. As a rule of thumb, the sooner you will need to draw income out of your portfolio, the lower your risk tolerance will be.
Step 2: Design a portfolio that accomplishes your stated objectives with the least amount of risk or uncertainty possible. Note the wording: The goal isn’t necessarily to “maximize your returns.” If you start with that as your primary focus, you risk taking on more risk than is prudent – and potentially coming up well short of your goals. The prudent path is to focus on your specific individual goals.
Now, this does not mean you don’t have risky assets in your portfolio. You may have quite a bit of them. Decades ago, an economist named Harry Markowitz won a Nobel Prize for his work demonstrating mathematically that by using risky assets in combination, an investor could realize the long-term benefits of each risky asset, while actually reducing the volatility of the portfolio as a whole. So by combining two risky asset classes with positive long term prospects but uncertain near term prospects, the short-term price swings of each of the two investments could largely cancel each other out. But they both do well in the long run. This concept, called diversification benefit, was a hallmark of Markowitz’s landmark theoretical innovation, Modern Portfolio Theory, or MPT
Now, MPT can work very well for institutions, who don’t have the same kinds of individual goals that individuals do. They also tend to have more resources for financial analysis and decision-making – and much longer time horizons. The pension fund is planning ahead generations. You may be planning ahead for a retirement that’s only a few years away.
For this reason, you may want your investment and savings vehicles to come with guarantees. And this is where insurance professionals come in: Unlike mutual fund companies and stockbrokers, insurance products generally come with some specific contractual guarantees. For example, you can place your money in assets with the following features: A guaranteed benefit to your family in the event of your death, a guaranteed minimum income benefit, a guaranteed minimum withdrawal benefit, a guaranteed check each month for life, a guaranteed death benefit, a guaranteed cash value benefit, and many other variations.
In the long run, these guaranteed solutions may or may not perform as well as what stockbrokers can sell. But they are guaranteed. And by focusing your portfolio on your goals, rather than on simply maximizing your returns, you may be able to accomplish your goals with guaranteed funds, and take on very little risk of failing to achieve them at all – so long as the insurance carrier remains solvent, of course.
You and your financial and insurance professionals map out a plan of action at this stage, combining insured, risky and risk-free investment and savings vehicles together with your goals paramount. You then invest your money according to this plan.
Part of the process, too, is assessing the different categories of risk to your portfolio – and ensuring you aren’t overexposed to any one hazard. For example, you and your financial professional may examine how well your portfolio protects you from these risks:
- Inflation risk
- Market risk
- Interest rate risk
- Default risk
- Company-specific risk
- Industry-specific risk
- Exposure of assets to lawsuits and bankruptcy
- Legislative risk
- Regional economic risk
- Fire, flood and theft
- Long term care risk
- Untimely death or disability
- Unemployment risk
- Longevity risk – the risk of living too long!
The risk budgeting process involves combining investment, saving and insurance solutions to prevent any of these risks from jeopardizing your ability to realize your financial dreams – while still taking enough risk to be able to earn inflation-beating returns.
Step 3: Monitor
As markets roil around, your risk exposure profile will change, too. As you near retirement for example, longevity risk may be more dangerous to your financial plans, while disability income insurance and life insurance take a lower priority. You may be less willing to bear market risk as you grow older, but more willing to accept some inflation risk if you can trade aggressiveness and potential upside for safety of principal. A younger worker has more time to recover from a bear market than an old one – and if you’re still earning income from work, a bear market can be a long-term opportunity to pick up assets on sale for your long-term benefit.
Similarly, the risk profiles of different assets change over time, too. For example, long-term bonds paying 2 percent interest don’t offer much upside, though they can be quite volatile as interest rates fall. And real estate where the mortgage payment is higher than the monthly rental value is riskier than real estate that generates positive cash flow when rented out. The same property can be relatively risky at one point in time, and then relatively safer (though never risk-free) at a different point in time.
The monitoring process simply assesses the changing risk profile of your portfolio periodically, and makes sure that you are still not over-exposed to any single potential hazard, and assessing your risk exposure in light of your shortening time horizon and financial objectives.