How You Measure Risk Will Affect the Success of Your Retirement
How You Measure Risk Will Affect the Success of Your Retirement, The measure of someone’s Risk Tolerance has changed quite a bit over the past couple of decades from not asking at all to being a litigious foundation in the new DOL Fiduciary Law. When financial advisors (stock brokers at the time) would ask (that’s assuming they did ask and not simply check a box) it was a multiple choice with options such as conservative to moderate to aggressive with maybe a couple of options in between. Back at the turn of the century, the industry added a little more emphasis especially as the population aged on articulating the five or eight multiple choice answers to gauge and to make recommendations based on the client’s comfort level of risk.
Nothing epitomizes this financial planning term than the advent of Target Funds. One core belief is all that is ever saved for something big is that the older you get the less risk you should take. Seems reasonable, but some very bad things happen within the uncertain cloud of reasonableness. However, there is some wisdom in not treading in bumpy waters when you have less time to recover from market corrections. So, what could go wrong with that logic?
Target Funds have their place in retirement plans and 529 plans. An easy access to a hands-off professionally managed account whose embedded promise is to lower the volatility of the portfolio by rebalancing into a higher concentration of fixed income assets while the equities move towards blue chip and dividend oriented stocks. Increasingly safer asset management may prove to be more detrimental to the objective rotating away from loss and straight into a disparaging risk v. reward ratio. Considering the high cost of management embedded in these types of assets, there is no wonder why those institutions love them so much.
Think about this way. As your portfolio gets closer to target date, the less active management is involved in your portfolio. Simply stated there are less costs involved in number and quality of staff, ongoing research and trading fees for the fund which translates to higher profitability for company all the while you are exchanging advisor fees for lower volatility. Bottom line, your net rate of return you receive on the risks you are taking with your portfolio is not in your best interest. But to be fair, we must measure how much do the advisor fees impact the rate of return and we also must measure quantitative amount of risk inherent in every investment.
As a true steward of your money, there is one foundational principle that cannot be disputed, yet it is never discussed. It’s not mandated by the government agencies, compliance officers or financial planning, yet this principle almost always is an integral part of investing. Many companies and financial planning software programs start the process of measuring risk in a portfolio as it compares to the stated tolerance level. With linear statistics, these retirement tools create an ambiguous rating or number system that is supposed to tell you if your portfolio is within or outside of your risk tolerance. This is primitive at best and dangerous at its worst. How the industry measures risk and the process they go about it is backwards and if not understood and corrected, there are going to be a lot of depleting portfolios the next time we have even the slightest market correction.
Let’s first discuss “linear statistics”. If you have ever read a Morningstar Report or looked up a stock on the internet you’ll know them as average rate of return, standard deviation, beta and alpha. We are not going to get too far in the weeds on stats; however, we do need to introduce “geometrical” math. Simply stated it is mathematics that gives a true measurement of how an investment actually performs. As an example, let’s say we start with $100,000 and over 10 years it grows to $150,000. Linear math tells us to divide the gain ($50,000) by the number of years (10) to get the average rate of return to come up with 5%/yr. When stock reports show average rate of return, they take the starting number and subtract that from ending number and divide by whatever term they are reporting. Unfortunately, that is not the true performance of the investment. If we took 5% gain and added it the starting principle, we would have $105,000 but when we add another 5% to the principle amount of $105,000 we will have $110,250 and not simply $110,000. So, if we stretch that over ten years we would have accumulated $162,890. Conclusively, the Compound Annual Growth Rate is a geometric statistic and measures the investment growing at 4.15% annually instead of the reported 5%. This distinction is extremely important when you are considering the costs of financial advice and the amount of overall risk you taking for the net reward you are receiving.
Now, of course we all beta is how an investment is measured in its volatility compared to an index, most notably the S&P 500. The beta is reported as a factor so the number 1 (or 100%) states that the investment will mirror exactly as the market moves where if you are above one your investment will move more than the market and if it is lower than 1 then the investment should move less than market. If you watch your portfolio closely, I am confident that you have had investments that inexplicably moved contrary to its beta where you were expecting great gains when the market turned North but your investment lagged or worse, the market moved down slightly but your investment had a considerable correction. We will explain why that happened a little later in this article. Now, I mentioned alpha, it is a linear statistic that pretty does the same thing as beta but measures itself against other like investments.
The last linear measurement, standard deviation is used primarily to show how much your investment can go up or down from zero. The higher the variance, the more it goes up or down over a certain period of time. Now, most of your retirement tools, risk assessment calculators use these statistical data to create a picture for the overall likelihood of success during your retirement years. These software programs look over the past 10 – 20 years of your current portfolio to quantitatively measure the average rate of return, the variance and the beta to let you know if you are on the right track. There are several problems with utilizing this strategy. First, who’s portfolio looks the same as it did 10 years ago? 5 years ago? Last month? Secondly, aren’t we supposed to change our portfolio to less Risk as we get older? Lastly, since when is it necessary to carry a lot of Risk to garner a good rate of return? One question I like to ask our clients and students, if you were going to lose 1% off an investment, would you like it priced at $600/share or $5/share? Yet, the standard deviation for Google is 0.66 per Morningstar, but when you consider its price, the standard deviation is over 34.
A couple in their mid-50’s, diagnosed by a financial advisor as Moderately Aggressive and even gave them a Risk Tolerance score of 78. They were comfortable with that amount of volatility in their investment portfolio which means that any given 6 month period the portfolio can go down 12% if they know that the upswing is closer to 18%. Let’s consider the investments and understand why this linear approach can be devastating to this couple’s retirement success. It is possible that the basket of stocks, whether its individually held or through ‘packaged’ products (mutual funds, ETF’s etc.) is heading South. These types of retirement risk analysis programs are all built on one premise and that is the markets, over time, always go up. That is empirically wrong. Population size always goes up; inflation always goes up and these two factors alone have more to do with market appreciation than the number of buyers over sellers. Besides, there have plenty of examples where ‘time’ has gone on for years and who can afford that during retirement years?
Another factor that is not implicated throughout this analysis is cash-flow. As they are calculating your Risk assessment against linear data, they are also figuring out your experience to quantify your risk tolerance. Now part of your experience has much to do with your 401k where you continually add money to your retirement account. Having a consistent injection of money and not having to lean on those assets, even with a market correction, softens the experience. As you are adding money, when there is a downturn you are buying more shares at a cheaper price so when the market appreciates you have more of a bounce. So, for your retirement, you must adjust your comfort level of risk because a 10% correction in the market doesn’t necessarily mean a buying opportunity. To fully understand your true risk score, we will need to take a geometric look at volatility and how we can utilize it to your advantage.
Let’s consider our couple’s portfolio. They were given a Risk Tolerance Score of 78, Moderately Aggressive. From those parameters, this couple along with their financial advisor and the compliance department will create, manage and balance a portfolio that assimilates the appropriate variance. What everyone reacts to however, is when the portfolio goes down too much. Usually the financial advisor will state that there is no way to control the market, the market will come back and that this portfolio fit within their guidelines of risk. So, why did it go outside of their risk score? Sometimes, to get certain transactions through compliance, the financial advisor will slide the risk tolerance a little higher than your comfort level, but that’s an ethics question and we are not here for that. More than likely, the reason is that the assets bought or managed did not look at the geometric data that should have shown there was much more embedded risk than the linear statistics reported.
A group of stocks with historically low volatility bought at the wrong time will have a much higher risk exposure. Isn’t it more accurate to say we know that market goes up and down but over time we expect that our risk will be rewarded with a proportionate rate of return? Your portfolio could have many stocks that either have a negative slope, could be bought at the ceiling with little history of pushing past or has more momentum to trade underneath its mean than above it. Your true risk should be measured in how likely you are to make money on an investment than lose money in the short term than over 10 or 20 years. A geometric assessment apportions a measurement for each holding would permit a precise allocation of investments essentially lowering the risk and allowing greater opportunity for appreciation because it would show when there is more danger to capital loss than gain.
You can’t forget the price. The adage “Buy Low, Sell High” seems to go by the wayside when it comes to risk assessment calculations. The markets have gone up continually for almost 7 years so no one needs to pay attention to the fact that they might be paying too much for an investment because it seems, prices just go higher. Another financial planning foundational principle is Opportunity Risk. This is where you chose one course of action when you could have chosen another where there was ample opportunity for a better result. Since we have time, taxes, fees and inflation as a constant adversary against the success of a portfolio, it seems that it would be imperative to understand the fluidity of risk assessment and how dynamic the levels of risk are in your portfolio.
A geometric measurement of a stock’s current price compared to its slope; compound annual growth rate; mean; highest price points; lowest price points; how many times the price has go through the ceiling and the floor and by how much; and how long a stock stays above it median or below it. Stock prices are like driving a car. As you are approaching a stop sign, you apply the brakes. As a stock is nearing the lowest price, it more than likely will slow down before getting to the stop sign. There is less risk as the price is getting closer to the floor, especially if there is a positive slope (positive trend line). Conversely, the closer a stock price gets to its peak the higher amount of risk becomes evident. If understand where the price is along the trend line, the overall momentum and how often it is not contained within its own variance we can ascertain a clearer, up-to-the-minute risk assessment for each holding and the overall portfolio. As you calculate the needed compounded annual growth rate, a fluid risk assessment of your holdings would allow to dictate how much dynamic risk you need to take throughout your retirement. As you can see in this graph, even a stock with low volatility can have a high-risk score and the last thing you would want is to believe you have a conservative portfolio when you don’t.