by Lars Kroijer
If we had done the same exercise and found that our retirement savings fall short when investing only in the minimal risk asset we would have been faced with some tough choices. The way you respond to this shortfall relates to your personal attitudes towards risk:
You could contribute more to your portfolio on an on-going basis if you are fortunate enough to be able to do so, or find a way to have a larger initial amount.
If you are very risk averse you may not be willing to accept any risk with your retirement funds and simply accept a lower annual retirement pot.
If you increase the equity allocation, the additional expected returns from equities will increase the chance that you have enough money for retirement. But while you increase the chance of achieving the target savings and on average will have more money in retirement, you do so at the expense of potentially incurring a greater shortfall in the cases where future equity markets are bad.
Risk/return
We can use the example above to get a sense of the price we pay for the surety of having enough money at retirement.
In the 50% minimal risk/50% equity case we would expect to have approximately £653,000, while the minimal risk only portfolio would give us £497,000. A difference of over £150,000 to use in our retirement! And the cost of that expected additional amount? Accepting that there is roughly an 18% risk that you will not have enough money to take out £20,000 a year in retirement.
The decision whether those additional expected assets is worth the risk of a shortfall in retirement often depends on personal circumstances. What will be the impact on your life of falling short of assets in retirement? Will this be catastrophic or just a mild annoyance? Hard to tell. Similarly, what will be the impact on your life of having significant excess funds? Will it make you happier? Does it mean that you can afford a better life for your children than you had yourself? Or perhaps you can leave them with a nest-egg that you could not otherwise afford.
Below are the results of running the iterations with various fractions of the assets invested in the minimal risk asset:
The bottom line of the table illustrates the amount of assets we are left with in the fifth per cent worst outcome, or every twentieth case. It is no surprise that the fifth percentile number gets worse as we increase the equity portion. With the higher expected returns from equities come the higher risk and the 5% worse cases therefore get progressively worse as we increase the equity allocation.
An unfortunate soul caught out by the drop
It’s 2007 and my friend had liquid savings of $500,000. She had decided that to live comfortably in retirement and to pay for the remaining years of her child’s education, she needed $425,000. She was a couple of years from retirement so the potential to add to savings from her current job was limited. Because of what might be perceived as the attractive risk/return profile of the stock market she had half her money in an equity index fund abroad and the other half in government bonds. Given the low expected risk of the market at the time it seemed like a sensible and conservative allocation – also, while she needed $425,000 she could find a good use for any extra!
Now it’s March 2009 and my friend is panicking. Her savings are down to $375,000 as she has lost about half on her equities, while the bonds are roughly flat. But not only has she lost 25% of her assets, her adviser tells her that now equities are super risky and that she could easily lose more.
Should she cut her losses and adjust her life choices to a lower quality of life, stay the course and consider this a large bump in the road? Or perhaps even double down and shift some assets from governments bonds into equities, in order to recoup the losses?
A lot of people found themselves in some version of this scenario at the peak of the panic.
Generalising the examples
Like any financial model this is the case of rubbish in, rubbish out. Models are only as good as the assumptions you put into them. The model above is based on some pretty generic assumptions about risk and return, and only incorporates the minimal risk asset and equities. You might disagree with those assumptions and be more aggressive about your return expectations or risk. You may want to run the model assuming 0% real return from your minimal risk asset in line with the current market, or introduce some risk to the return of the minimal risk asset.4 Or you could move away from having a 50/50 allocation to minimal risk assets/equities in the portfolio, depending on your risk tolerances.
Instead of continuing to adapt a financial planning example that may not be entirely relevant to your financial planning needs, I would encourage you to do this kind of financial analysis yourself or to get someone to help you with it. You can do financial modelling in Excel, in Google Drive or use one of the many financial software packages available. In any case, make sure you spend enough time figuring out how everything fits together, and confirm that the model fits your specific needs.
It could be that you want to get an overview of what $100,000 invested in equities would get you in 10 years’ time with the same assumptions on risks and returns (see Figure 10.2). Or it could be that you want to figure out the probability that the money you have put aside for your children’s education will suffice. You might be an insurance company or pension fund that wants to find the probability of having enough funds to meet your future liabilities. The list is endless.
In any case, building a financial model that considers the range of potential outcomes will probably spark your thinking about the impact that the various outcomes will have. Take the model and amend it to roughly suit your situation. Then start playing with the inputs, assumptions and allocations:
Have you been too conservative/taken too much risk?
Could you bear bad equity markets in the decades ahead – what if they are riskier?
How much is your situation likely to change in future? How will that impact on your risk profile?
Figure 10.2 $100,000 invested in equity markets after a 10-year period
Is it possible that your financial goals are incompatible with the risk you are comfortable taking?
What is the lowest 5% of outcomes? Lowest 2%? Could you handle it? Would you be willing to accept that you could fall short in one out of 20 cases? One out of 50? Never?
Do you have a ‘drop dead’ level of assets that you simply are not willing to fall below? How does that dictate your allocations?
As ‘touchy-feely’ as it sounds, try to feel what would happen in various cases. What does your gut tell you? How would it affect how you sleep at night? Your career? Your marriage?
What would happen to your other assets, job, etc. at the same time as any fall in the markets? Would they reinforce what is happening to you or offer respite?
Investing time in understanding the risks of your portfolio or financial goals is a worthwhile undertaking whether through a model like this or any other means. Even in the scenario when you don’t change your thinking or portfolio as a result, the increased understanding will probably lower the emotional strain of adverse events. You have an idea of what might happen and what the consequences could be for you.
A few important points to remember when using a model like the one above:
The model is very simple and built with some very basic assumptions, but be cautious about those that add lots of products with high returns and low correlations. This will enable people to come up with much better risk/return outcomes, but as rational investors we do not think it can be done (indeed rubbish in, rubbish out).
The model does not incorporate corporate bonds and government bonds that could be a worthwhile addition to the simple rational portfolio. This is a simplification. Incorporating those two asset classes would involve estimating correlations between them and equities, which is a science in itself (and a constantly moving number). Besides, adding other government and corporate bonds is not a magic bullet for the portfolio; while those asset classes are good diversifying additions to the portfolio they are not without risk.
The model is v
ery sensitive to the inputs, particularly on risk, and does not account for some of the issues with using standard deviation to gauge risk that was discussed earlier (in Chapter 6). Changing the inputs would make a massive difference to the range of outputs. If you do change the inputs, make sure you understand why – don’t make ‘nicer’ assumptions just because you like the results better. The expected real return on equities will not be 10% a year just because you put it in a spreadsheet.
Keep in mind that all the returns are real returns. So the model is in today’s money. Clearly the actual numbers decades from now will look very different because of inflation.
Keeping it real
If we have got to the point where we have built a financial model that reflects our situation and implemented our investment plan by purchasing the right products (see Chapter 14 on products and implementation) we are doing really well. Unfortunately that is not the end of it.
We have to keep an eye on our portfolio and financial model and adapt it to changing circumstances and, if nothing else, then the passage of time. Imagine a scenario where the market has moved up 50% in a year. As we look at our financial planning we would be remiss if we didn’t somehow take our new and improved financial situation into account in our forward planning. It could be that with our higher asset base we are able to reach long-term financial goals with a far lower risk.
When we periodically look at our portfolio in the context of our overall financial health it may also be that our personal circumstances have changed, which in turn could affect our financial plans – we were promoted, fired, received an inheritance, got divorced, the uninsured car was stolen, our tax circumstances changed, etc. It all matters. How often we do this kind of review is a personal decision, but at minimum you should aim for yearly or whenever there has been great turbulence in the financial markets or your personal life. Since you should rebalance the portfolio periodically anyway that would be a good time to review its composition. I’ll come back to rebalancing later.
Reacting to disaster
In the aftermath of the 2008–09 financial crisis many investors were understandably left aghast. Many had lost far more money in their portfolios than they thought possible, and often did so as their house and other assets also plummeted in value. The gut reaction for many investors was to sell their equity exposure at or near the bottom of the markets, only to miss out on the great rally that followed. ‘A familiar story of retail investors abandoning their plans’, some financial planners lamented.
I don’t think things are that simple. During crashes like 2008 there is a natural tendency for everyone to have a view on the markets. The markets will dominate the headlines and be a topic of conversation at work, the gym, meals out, in homes and everywhere else. How can you not have a view?
The point is that we still don’t have a view. While many people with the benefit of hindsight say they saw the rebound, ‘just’ because there is great market turbulence does not mean that an investor is better able to predict market movements. We don’t consider ourselves smarter than the average dollar invested in the market, and that average dollar put the S&P 500 at an index value of under 700 in March 2009. The fact that four years later we see that same index trading around its all-time highs does not mean that we could predict in March 2009 that this would be the case.
When you look back at the 2008–09 crises or any crises preceding it, many people have a sense that there is a bottom somewhere, and great profits to be made for investors who find the bottom. And clearly that has often been the case. If you had stayed the course or invested more at exactly the right point in March 2009 (or July 1932) you would have made a lot of money. But you obviously did not know that then. For all you knew at the time, March 2009 was just a precursor to a really bad decline in the market, and you were scared to death. There is no guarantee that markets bounce back after a decline. Just ask investors who bought Russian equities in 1917 …
But that does not mean that there is nothing you can do. First of all, after bad declines in the market it is likely that the future riskiness of the market has gone up a lot in the general turmoil. While that does not give market direction at least you can prepare yourself for the increased risk. Those willing to bear the extra risk will probably see commensurate higher expected returns, but they have to be willing to accept that a lot of money could also be lost.
We know that losses like those in 2008–09 do happen with some frequency and it is at times like these that you hope to benefit from having had a conservative allocation policy, instead of selling your holdings in desperation.
In any case there are no easy fixes and we are faced with a few unpleasant alternatives:
We can find a way to put more money aside in savings.
We can accept a lower amount in retirement or the same amount for a shorter time period.
We can reallocate between the minimal risk asset and equities if the large decreases have affected the risk we are willing to take with our portfolio.
Though it sounds like annoying hindsight, investment allocations are about ensuring that you don’t find yourself in the position of making panic sales to start with. Have enough of a buffer so that you avoid selling equities at what might be the bottom of the markets. Over the long run, equity markets are likely to far exceed government bond returns, but they will also be far more volatile and periodically lose you a lot. Make sure your allocations allow for that.
A few ways to think about portfolio allocations
Here are some suggestions:
Drop dead allocation If you need £100 for heart surgery, don’t buy equities with your last £105. Have enough money in the minimal risk asset so that you certainly have enough in the short term, and only then start adding equities.
Pick a return point and see if you can handle the risk You may expect 0.5% per year from the minimal risk asset and a premium to that of 4–5% from a broad equity index, both after inflation. You can pick the return point you are after, and then figure out the risk required to achieve your goals (see Figure 10.3).
A word of caution: if you borrow money to achieve higher returns than those from equities keep in mind that those loans tend to get recalled exactly at the worst time and lock in your losses.
Pick a risk point and see what returns you can expect How much risk you can handle is subject to your personality and individual circumstances. You can work out your worst 1%, 2%, 5%, 10%, etc. scenarios to see what various portfolios look like, and get an idea of the risk you are willing to take. Put this in the context of the consequences of failing to reach your financial goal and guide your allocations that way.
Figure 10.3 What can you expect at the end of the year from £100 invested on 1 January of the same year
Think about the flexibility of your financial goals As you consider your portfolio allocations it is worth keeping in mind what is implied by the end portfolio value you are trying to achieve. Does your goal suggest the minimum of financial survival or meeting a firm liability with its nasty potential consequences of failure? Or does your target really suggest more of a ‘nice to have’ lifestyle pot of assets? These considerations should play into the risk you take with the portfolio.
Think about avoiding temptation Set your portfolio up so you have some flexibility in case the markets move unexpectedly. Reallocations are costly and retail investors are notorious for selling their equity holdings at the worst time. Generally avoid trading in and out of things excessively – it’s costly and will significantly reduce long-term returns.
Use market experience Think about how you react to losing money as the markets inevitably drop on occasion. If you can’t sleep at night for worry about the future or sell after the decline then your equity allocation is probably too high. On the other hand, if you think ‘that’s nothing’ and want to add more equities then you were probably too risk averse in your allocations. Sometimes it can be hard to know exactly how you will feel until the moment happens, and it can be hard to pred
ict how other parts of your life would be affected by a drop in the markets.
Impact of non-financial assets and liabilities As you think about the risk in your investment portfolio, consider how other assets and liabilities are affected by the same factors. Make sure that not too many bad things can happen to you at once, both from a value and liquidity perspective. Should the world equity markets experience a calamity, it is possible that the value of your house, job (an equity broker will be affected more than a civil servant, etc.), and other assets all decline at the same time. Those things are not as liquid as the rational portfolio. Be sure to avoid a distress sale of your only liquid asset (the rational portfolio) in bad markets by minimising illiquid assets that all drop in value at the same time. Meanwhile, your liabilities are often more fixed.
It is often a great idea to put your portfolio objectives and risk tolerances into words in a simple ‘portfolio mission statement’. Unless you are so inclined, the statement does not have to be accompanied by a picture of a soaring eagle, but be something for you to look at occasionally, and particularly as your circumstances change. It helps to think of why you are saving up or allocating between equity and bonds and the maturity profile of those bonds. It could also be helpful for you to put into words how you would react and feel about bad things happening in your portfolio. If nothing else, this forces you to think about how you would react to various scenarios and potentially restructure your portfolio as a consequence of something not sitting right with you.
