January 6th, 2020 – 5pm –

Asset allocation can be loosely defined as an individual’s exposure to stocks versus bonds. Risk tolerance is the measure of a person’s ability to withstand portfolio volatility and thus plays a direct impact on an individual’s asset allocation. Historically, it has been a common practice to correlate risk tolerance with age, with the general idea of the time it may take to recoup losses. For example, one person in the mid-20s may have an investing time horizon spanning 45 years until retirement and another 20 years through life expectancy. In total, this individual’s investment time horizon may be 65 years or more. It is a safe assumption that this individual has the ‘time’ required to make up losses should the market undergo any significant corrections; and, therefore, has a risk tolerance that is aggressive. On the flip side, an individual already within retirement, let’s say at the age of 70, may have a total investable time frame of 10-15 years; and, therefore, does not have the time to make up losses. Next to a no risk tolerance plan, this is acceptable; however, in my opinion, it only scratches the surface when it comes to portfolio allocation and risk. 

You see, over the last 20 years as an adviser, I have learned that people tend to underestimate their real risk tolerance when it comes to declines in dollar terms.  For example, I have yet to meet an individual with a portfolio of $200,000, regardless of age, who would be OK with a decline of $100,000 or more. Let’s face it, every single person wants to make as much money as possible when markets rise, and lose nothing when markets decline. It is for this reason that structured products, offering bells and whistles with unbearable strings, even have a market. 

You see, when approaching risk tolerance, I believe there has to be something more and investors have to dive a bit deeper to understand risk and the asset allocation that is truly right for them. 

Most advisers, when conducting a financial planning review, will solve for an individual’s ending balance. For example, they will seek to develop a financial plan with an understanding of a person’s existing investment values, contribution amounts, desired retirement age, spending habits and general life expectancy. Using an age-based risk tolerance assumption, the planner will then input hypothetical rates of return based on general market history. They will hit the compute button and the result will be a number that tells planners whether or not the individual will have enough money. If the number is positive it’s all good; if not, there’s work to be done. 

While any plan is better than no plan, I believe this basic methodology is flawed in the area of the return assumption and, therefore, the individual’s risk assumption. 

Let me give you an example. Let’s say that an individual is approaching retirement and is planning on drawing Social Security along with a rare, but still seen on occasion, company pension. The combination of the two is sufficient to meet the income needs, unless there is an unforeseen emergency, so that retirement assets will not be touched. The planner, recognizing this, develops a plan that shows the investments growing at an average rate of 6%, due to a standard asset allocation mix of 60/40. Of course, since the retirement assets don’t need to be used and therefore are free to compound, the prospective client is pleased to see a significant gain in assets throughout life expectancy. Then, a bear market sets in. 

Sticking with the same assumption, let us assume the individual has approximately $1MM in retirement assets and, during a general market decline of 30%, sees approximately $180,000 decline in the portfolio. Significantly disappointed in this decline, the client seeks a new adviser. 

On one hand, the adviser takes the position that the client was in a diversified portfolio with an asset allocation of 60% stocks and 40% bonds. While unfortunate, the decline is perfectly acceptable within a portfolio mix such as this. The client, on the other hand, is upset that with no real need for the retirement funds, the risk associated with the funds was unnecessary and imprudent. Both are dissatisfied, and the net result is another black eye on the financial planning industry and an unhappy client. 

From my vantage point, the problem was not in the asset allocation mix, the market decline, the adviser’s expectations or the client’s expectations but in the planning process itself. Rather than the adviser stopping with the input of hypotheticals, the adviser should have also solved for the minimum required rate of return the client needed, thus understanding the minimum amount of stock exposure and minimal risk. 

In our previous example, the client had ample income to meet the budgetary expectations; however, with rising inflation possibly outpacing the social security and pension, quite possibly the required rate of return for the investable assets may have been as low as 2 – 3%. What this means is that the client would only need an additional 2 – 3% in the portfolio to keep up with inflation; and, thus, never outlive his or her money or significantly change spending habits. With this information, rather than a standard 60 – 40 portfolio mix, the client could have gone as low as 20 – 30% in stocks and still have met the goals. 

When the inevitable bear market came, rather than seeing a portfolio decline of $180,000, the client may have seen as little as a 6% decline, and, more than likely, have seen most of this offset with a rise in bonds. 

In today’s advisory world it is prudent to seek a fiduciary fee-only advisory firm. Data has proven that a low fee, passive index portfolio is a must, and by following standard dollar-cost averaging, rebalancing practices will ensure longer term success. While these attributes are foundational, the process by which we determine risk tolerance and allocation seems antiquated and in desperate need of revision. If you haven’t examined your portfolio already, we strongly encourage an approach by which your required rate of return is determined before any discussion regarding an allocation ensues. If you’d like to discuss more, please contact us for a meeting and we’ll be happy to share our thoughts.