Recent data from the Federal Reserve highlights that the U.S. saw a 12.5% increase in the population aged 55 to 64 between 2004 and 2007. Near retirement, and typically beyond their largest earning years, this group faces tough decisions about their investing and spending even in good times. Today, because of large declines in the value of the stock market and residential real estate, those decisions are harder than ever. Traditional assessments of portfolio risk have been inadequate for a long time, but for this group it is even more relevant to discuss the importance of relating the assets to the liabilities of the investor.
I recently came across a compilation of articles from the Journal of Portfolio Management that were published in a 1998 compendium called Streetwise (Princeton University Press). A 1984 article, "A New Paradigm for Portfolio Risk," by Robert Jeffrey, caught my eye.
In "A New Paradigm..." Jeffrey argues against using only portfolio volatility as the measure of portfolio risk. His underlying assertion is that risk is a function of a portfolio's liabilities as well as its assets, and in particular of the cash flow relationship between the two over time.
The new paradigm that Jeffrey argued for in his 1984 article never occurred. For the past 25 years it has been standard for individuals to construct portfolios that offer the promise of the greatest return for the maximum tolerable amount of risk, defined as portfolio volatility.
For the most part, individuals have not been encouraged by mutual fund companies and large brokerage firms to think about their portfolio risk in terms of their liabilities. The business models of these firms can be called "manufacture and distribute." What they manufacture are the mutual funds and other products that they market to individual and institutional investors. Most likely, the asset based approach to risk management, generally advocated by these firms, is a product of the fact that portfolio assets are what they manufacture. Yes large brokerage houses do offer mortgages, but in my experience this is a discreet function, perhaps facilitated by the client's sales rep, but not incorporated into the portfolio risk discussion.
The problem with volatility based risk measures, as Jeffrey points out, is that they say nothing about what is being risked as a result of the volatility. Said another way in the same article, "the determining question in structuring a portfolio is the consequence of loss; this is far more important than the chance of loss."
The 50 or 60 Something investor, who faces tough decisions about investing and spending, needs to be considering the consequence of loss as highlighted above. This is a very personal exercise that requires a thoughtful breakdown of the timing, magnitude and predictability of future cash requirements. A competent advisor who works with the proper incentives can be an invaluable resource in this process by asking the right questions and highlighting opportunities for savings or realignment of assets. An objective, knowledgeable advisor is in a position to show investors the best of what is out there to meet their needs.
As always, investors should "consider the source" when receiving investment advice. In addition to educational background and years of experience, some key questions are; How much time does the person that I am working with spend trying to understand my whole financial picture? How is the advisor compensated? Does the advisor offer an "open architecture," or are the recommendations constrained by his or her firm's product line? Does my advisor receive commissions when I purchase something that may color his or her incentives? Is he charged with acting as a fiduciary?
Individual client risk management is improved by considering assets and liabilities together. Advisors who practice this approach can be invaluable in helping their clients with this.
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