Splitting the Risk
Parenting skills may be at their most critical level during the early morning hours associated with the kids leaving the house and getting on the school bus. “Bobby did you finish your breakfast? Bobby did you put your homework back into your school bag so you can turn it in? What about your lunch money? Don’t forget that I will be picking you up at the athletic field after practice. I just listened to the weather report: high likelihood of rain. Please wear your rain coat! What do you mean you don’t want to? Just because nobody else wears a rain coat does not mean that you can’t. OK, how about taking my umbrella? And please will you not leave my umbrella at school. Please, do not sit in the back of the bus, sit up front where the bus driver can keep an eye on you. (Bobby walking out the door….) I love you, and please be careful.”
Notice how the parenting skills went from addressing specific risks to addressing the overall risk of “be careful.” In money management, the major change over the last 50 years has been the acknowledgement of risk as being capable of being managed for. Prior to the 1970’s the risk was the gamble. The gamble was that the stock pick and subsequent investment in that same stock would go up in value. Pretty simple… Actual use of the principle of portfolio management was rolled out to institutions in the 1970’s. In its first rendition it was called diversification. The basic principles of diversification were: 1. Treat your entire list of investments as a unity (your whole portfolio). The actions of the individual investments were watched to see what the net results were in totality. 2. Adjust the investments in your portfolio so the way that they interacted with the other investments produced maximum reward for the risk taken… that’s what we call optimization. The previous sentences may seem pretty obvious today, but back then it was a new thought. Pivotal in this summary of diversified portfolio management is the assumption that we do want to manage for risk. In much the same way that parents may have to manage for risk during the breakfast pre-school bus hours, the critical question becomes: Which Risk?
Previously, I have written two other articles addressing the issue of risk: Robin Hood and the Objectification of Risk and, The Pain Chart. You may want to read them first before proceeding. The take-away ideas from the articles are: Can we really anticipate risk in advance? And, do modern risk questionnaires make it any easier? Then I wrote: What Is Investment Policy? This article, summed up, spoke to the importance of anticipating a process of assessment, the results of which might not be achieved all that easily; but were worth the work. The point of “Splitting the Risk” is that the process of attempting to assess future risk, done using a questionnaire, summed up in a written investment policy statement that is yours and yours alone in the most subjective meaning of the word, may be best fulfilled by splitting the risk. To be clear: it may be the best use of principles of portfolio management to address different kinds of risk with in the same portfolio.
Labeling and determining all the various kinds of risk is daunting. Identifying the various risks would produce a very long list … a long list, which in theory might not be of very much value to investment policy. Remember investment policy primarily has significance in that it applies only to your situation. And the major determinant of policy seems to be: How much money do you have relative to your personal goals? In theory that would mean that you either have enough money or you do not. The logic here is that if you have sufficient money you can be more conservative. And if you have insufficient money you might want to be more aggressive. The affliction in personal investment policy is that you have the right to do just the opposite. So the question becomes how is one going to deal with this conundrum? Moving back to identifying risks, let me suggest that relative to modern personal and social problems that the main risk is not having enough money. Government, private and public corporations just cannot afford to reward employees with a pension. A pension is defined as a guaranteed monthly income in retirement. The pension benefit is income based. Savings plans like a 401k, 403b, traditional IRA or Roth IRA are focused on the contribution side of things…the more you save the more you have. The problem is, of course is that does not address the issue of whether the saved amount will be sufficient to generate enough income. The income would in no way be guaranteed, unless private alternatives to pensions were used like annuities. Annuities do not solve the problem of enough income; they just solve the problem of predictable income. Thus, my suggestion, that having enough money is the ultimate risk.
Obviously the lack of money is not a portfolio risk! The lack of money may be the result of portfolio risk. But it is this very result that we want to guard against. So within the modern context of lack of money equals lack of income let me suggest three portfolio risks. Most risk is defined as portfolio volatility. Volatility is different from absolute loss. Volatility, negative volatility, implies that this state would be temporary. Just how temporary is of course the topic of a whole other discussion. Staying within the definition of risk as volatility let us break this down. 1. “End of World” risk: 50% volatility risk. 2.”Normal Market” risk: 10 to 20% negative volatility. 3. “Beat the Market” risk: risk assumed in attempting to beat a specific index, implying that you assume 100% of the risk of that index, whatever that index might be.
Here is a quick summary of what these risks are all about. “End of World Risk” assumes and implies that all risks be covered in much the same way that “the parenting skills are used in the breakfast arena moving Bobby to the bus”. The ultimate risk management technique applied to manage volatility in “Bobby’s World” is “Be Careful”! This statement implies the futility of managing for the specific risk, “make sure you bring home the umbrella”, and instead goes for the “End of World” approach…. “Be Careful”. “End of World” management, as defined in war like terms, may wind up shooting a few good guys. The goal of “bringing home Bobby alive” takes on a supervening importance. “ Normal Market Risk” is an approach that is willing to assume in advance that it is NOT worth shooting some good guys as a method of protection. A market correction is defined typically as 10% negative volatility. Periodically the 10% correction may broaden to 20%. This degree of risk will be tolerated. And finally “Beat the Market Risk” presupposes an indeterminate amount of risk that could theoretically exceed 50%. In the past an attempt to “beat the market” presumes that more risk must be assumed to make the beating possible. The classic statement is: if you want to beat an established index you must take on additional risk. My approach instead, uses the seasonal differences in the market to execute a “Beat the Market” without taking on additional risk.
Ok, let me finish on this note: why is it important to define risks into these three: “End of World”, “Normal Market”, and “Beat the Market”? The answer is that a growing understanding of what your investment policy should be requires a deliberately defined and protected world. Gaining experience is clearly the answer. The more you learn the more you know. Being able to watch the performance and volatility associated with 3 different approaches gives you the room to grow. We at Minich MacGregor Wealth Management are all about risk management. The gist of this article is that there are varying types of risk. It is possible that your success in meeting your goal of having enough money can be furthered by splitting the risk.