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- For most investors, long-term “failure” means not meeting one’s financial objectives.
- In the portfolio management context, failure comes in two flavors. “Slow” failure results from taking too little risk, while “fast” failure results from taking too much risk. In his book, Red Blooded Risk, Aaron Brown summed up this idea nicely: “Taking less risk than is optimal is not safer; it just locks in a worse outcome. Taking more risk than is optimal also results in a worse outcome, and often leads to complete disaster.”
- A third type of failure, failing very fast, occurs when we allow behavioral biases to compound the impact of market volatility (i.e. panicked selling near the bottom of a bear market).
- In the aftermath of the global financial crisis, risk management was often used synonymously with risk reduction. In actuality, a sound risk management plan is not just about reducing risk, but rather about calibrating risk appropriately as a means of minimizing the risk of both slow and fast failure.
On the way back from a recent trip, I ran across a fascinating article in Vanity Fair: “The Clock is Ticking: Inside the Worst U.S. Maritime Disaster in Decades.” The article details the saga of the SS El Faro, a U.S. flagged cargo ship that sunk in October 2015 at the hands of Hurricane Joaquin. Quoting from the beginning of the article:
“In the darkness before dawn on Thursday, October 1, 2015, an American merchant captain named Michael Davidson sailed a 790-foot U.S.-flagged cargo ship, El Faro, into the eye wall of a Category 3 hurricane on the exposed windward side of the Bahama Islands. El Faro means “the lighthouse” in Spanish.
The hurricane, named Joaquin, was one of the heaviest to ever hit the Bahamas. It overwhelmed and sank the ship. Davidson and the 32 others aboard drowned.
They had been headed from Jacksonville, Florida, on a weekly run to San Juan, Puerto Rico, carrying 391 containers and 294 trailers and cars. The ship was 430 miles southwest of Miami in deep water when it went down.
Davidson was 53 and known as a stickler for safety. He came from Windham, Maine, and left behind a wife and two college age daughters. Neither his remains nor those of his shipmates were ever recovered.
Disasters at sea do not get the public attention that aviation accidents do, in part because the sea swallows the evidence. It has been reported that a major merchant ship goes down somewhere in the world every two or three days; most ships are sailing under flags of convenience, with underpaid crews and poor safety records.
The El Faro tragedy attracted immediate attention for several reasons. El Faro was a U.S.-flagged ship with a respected captain – and it should have been able to avoid the hurricane. Why didn’t it? Add to the mystery this sample fact: the sinking of the El Faro was the worst U.S. maritime disaster in three decades.”
From the beginning, Hurricane Joaquin was giving forecasters fits. A National Hurricane Center release from September 29th said, “The track forecast remains highly uncertain, and if anything, the spread in the track model guidance is larger now beyond 48 hours...” Joaquin was so hard to predict that FiveThirtyEight wrote an article about it. The image below shows just how much variation there was in projected paths for the storm as of September 30th.
Davidson knew all of this. Initially, he had two options. The first option was the standard course: a 1,265-mile trip directly through open ocean toward San Juan. The second was the safe play, a less direct route that would use a number of islands as protection from the storm. This option would add 184 miles and six plus hours to the trip.
Davidson faced a classic risk management problem. Should he risk failing fast or failing slow?
Failing fast would mean taking the standard course and suffering damage or disaster at the hands of the storm. In this scenario – which tragically ended up playing out – Davidson paid the fatal price by taking too much risk.
Failing slow, on the other hand, would be playing it safe and taking the less direct route. The risk here would be wasting the company’s time and money. By comparison, this seems like the obvious choice. However, the article suggests that Davidson may have been particularly sensitive to this risk as he had been gunning for a captain position on a new vessel that would soon replace El Faro on the Jacksonville to San Juan route. In this scenario, Davidson would fail by taking too little risk.
This dichotomy between taking too little risk and failing slow and taking too much risk and failing fast is central to portfolio risk management.
Aaron Brown summed this idea up nicely in his book Red Blooded Risk, where he wrote, “Taking less risk than is optimal is not safer; it just locks in a worse outcome. Taking more risk than is optimal also results in a worse outcome, and often leads to complete disaster.”
In the investing context, failing slow happens when portfolio returns are insufficient to generate the growth needed to meet one’s objectives. No one event causes this type of failure. Rather, it slowly builds over time. Think death by a thousand papercuts or your home slowly being destroyed from the inside by termites.
Traditionally, this was probably the result of taking too little risk. Oversized allocations to cash, which as an asset class has barely kept up with inflation over the last 90 years, are particularly likely to be a culprit in this respect.
Take your average 60% stock / 40% bond investor as an example. Historically, such an investor would see a $100,000 investment grow to $1,494,003 over a 30-year horizon. Add a 5% cash allocation to that portfolio and the average end result drops to $1,406,935, an $87k cash drag. Double the cash bucket to 10% and the average drag increases to nearly $170k. This pattern continues as each additional 5% cash increment lowers ending wealth by approximately $80k.
Fortunately, there are ways to manage funds earmarked for near-term expenditures or as a safety net without carrying excessive amounts of cash. For one example, see the Betterment article: Safety Net Funds: Why Traditional Advice Is Wrong.
Unfortunately, today’s investors face a more daunting problem. Low returns may not be limited to cash. Below, we present medium term (5 to 10 year) expected returns on U.S. equities, U.S. bonds, and a 60/40 blend from seven different firms/individuals. The average expected return on the 60/40 portfolio is less than 1% per year after inflation. Even if we exclude the outlier, GMO, the average expected return for the 60/40 is still only 1.3%. Heck, even the most optimistic forecast from AQR is downright depressing relative to historical experience.
And the negativity is far from limited to U.S. markets. For example, Research Affiliates forecasts a 5.7% real return for emerging market equities. This is their highest projected return asset class and it still falls well short of historical experience for the U.S. equity markets, which have returned 6.5% after inflation over the last 90 years.
One immediate solution that may come to mind is just to take more risk. For example, a 4% real return may still be technically achievable. Assuming that Research Affiliates’ forecasts are relatively accurate, this still requires buying into and sticking with a portfolio that holds around 40% in emerging market securities, more than 20% in real assets/alternatives, and exactly 0% large-cap U.S. equity exposure.
This may work for those early in the accumulation phase, but it certainly would require quite a bit of intestinal fortitude. For those nearing, or in, retirement, the problem is more daunting. We’ve written quite a bit recently about the problems that low forward returns pose for retirement planning and what can be done about it.
And obviously, one of the main side effects of taking more risk is increasing the portfolio’s exposure to large losses and fast failure, very much akin to Captain Davidson sailing way too close to the eye of the hurricane.
At its core, failing fast in investing is about realizing large losses at the wrong time. Think your house burning down or being leveled by a tornado instead of being destroyed slowly by termites.
Note that large losses are a necessary, but not sufficient condition for fast failure. After all, for long-term investors, experiencing a bear market eventually is nearly inevitable. For example, there has never been a 30-year period in the U.S. equity markets without at least one year-over-year loss of greater than 20%. 79% of historical 30-year periods have seen at least one year-over-year loss greater than 40%.
Fast failure is really about being unfortunate enough to realize a large loss at the wrong time. This is called “sequence risk” and is particularly relevant for individuals nearing or in the early years of retirement.
We’ve used the following simple example of sequence risk before. Consider three investments:
- Portfolio A: -30% return in Year 1 and 6% returns for Years 2 to 30.
- Portfolio B: 6% returns for Years 1 to 14, a -30% return in Year 15, and 6% returns for Years 16 to 30.
- Portfolio C: 6% returns in Years 1 to 29 and a -30% return in Year 30.
Over the full 30-year period, all three investments have an identical geometric return of 4.54%.
Yet, the experience of investing in each of the three portfolios will be very different for a retiree taking withdrawals. We see that Portfolio C fares the best, ending the 30-year period with 12% more wealth than it began with. Portfolio B makes it through the period, ending with 61% of the starting wealth, but not without quite a bit more stress. Portfolio A, however, ends in disaster, running out of money prematurely.
One way we can measure sequence risk is to compare historical returns from a particular investment with and without withdrawals. The larger this gap, the more sequence risk was realized.
We see that sequence risk peaks in periods where large losses were realized early in the 10-year period. To highlight a few periods:
- The period ending in 2009 started with the tech bubble and ended with the global financial crisis.
- The period ending in 1982 started with losses of 14.3% in 1973 and 25.9% in 1974.
- The period ending in 1938 started off strong with a 43.8% return in 1928, but then suffered four consecutive annual losses as the Great Depression took hold.
A consequence of sequence risk is that asset classes or strategies with strong risk-adjusted returns, especially those that are able to successfully avoid large losses, can produce better outcomes than investments that may outperform them on a pure return basis.
For example, consider the period from August 2000, when the equity market peaked prior to the popping of the tech bubble, to March 2018. Over this period, two common risk management tools – U.S. Treasuries (proxied by the Bloomberg Barclays 7-10 Year U.S. Treasury Index and iShares 7-10 Year U.S. Treasuries ETF “IEF”) and Managed Futures (proxied by the Salient Trend Index) – delivered essentially the same return as the S&P 500 (proxied by the SPDR S&P 500 ETF “SPY”). Both risk management tools have significantly underperformed during the ongoing bull market (16.6% return from March 2009 to March 2018 for SPY compared to 3.1% for IEF and 0.7% for the Salient Trend Index).
Yet, for investors withdrawing regularly from their portfolio, bonds and managed futures would have been far superior options over the last two decades. The SPY-only investor would have less than $45k of their original $100k as of March 2018. On the other hand, both the bond and managed futures investors would have growth their account balance by $34k and $29k, respectively.
Failing Really Fast
Hurricanes are an unfortunate reality of sea travel. Market crashes are an unfortunate reality of investing. Both have the potential to do quite a bit of damage on their own. However, what plays out over and over again in times of crisis is that human errors compound the situation. These errors turn bad situations into disasters. We go from failing fast to failing really fast.
In the case of El Faro, the list of errors can be broadly classified into two categories:
- Failures to adequately prepare ahead of time. For example, El Faro had two lifeboats, but they were not up to current code and were essentially worthless on a hobbled ship in the midst of a Category 4 hurricane.
- Poor decisions in the heat of the moment. Decision making in the midst of a crisis is very difficult. The Coast Guard and NTSB put most of the blame on Davidson for poor decision making, failure to listen to the concerns of the crew, and relying on outdated weather information.
These same types of failures apply to investing. Imagine the retiree that sells all of his equity exposure in early 2009 and sits out of the market for a few years during the first few years of the bull market or maybe the retiree that goes all-in on tech stocks in 2000 after finally getting frustrated with hearing how much money his friend had made off of Pets.com. Taking a 50%+ loss on your equity exposure is bad, panicking and making rash decisions can throw your financial plans off track for good.
Compounding bad events with bad decisions is a recipe for fast failure. Avoiding this fate means:
- Having a plan in place ahead of time.
- If you plan on actively making decisions during a crisis (instead of simply holding), systematize your process. Lay out ahead of time how you will react to various triggers.
- Sticking to your plan, even when it may feel a bit uncomfortable.
- Diversify, diversify, diversify.
On that last point, the benefits of diversifying your diversifiers cannot be overstated.
For example, take the following four common risk management techniques:
- Static allocation to fixed income (60% SPY / 40% IEF blend)
- Risk parity (Salient Risk Parity Index)
- Managed futures (Salient Trend Index)
- Tactical equity with trend-following (binary SPY or IEF depending on 10-month SPY return).
We see that a simple equal-weight blend of the four strategies delivers risk-adjusted returns that are in line with the best individual strategy. In other words, the power of diversification is so significant that an equal-weight portfolio performs nearly the same as someone who had a crystal ball at the beginning of the period and could foresee which strategy would do the best.
Achieving Risk Ignition
In the wake of the tech bubble and the global financial crisis, lots of attention has (rightly) been given to portfolio risk management. Too often, however, we see risk management used as a synonym for risk reduction. Instead, we believe that risk management is ultimately taking the right amount of risk, not too little or too much. We call this achieving risk ignition (a phrase we stole from Aaron Brown), where we harness the power of risk to achieve our objectives.
In our opinion, a key part of achieving risk ignition is utilizing changes that can dynamically adapt the amount of risk in the portfolio to any given market environment.
As an example, take an investor that wants to target 10% volatility using a stock/bond mix. Using historical data going back to the 1980s, this would require holding 55% in stocks and 45% in bonds. Yet, our research shows that 20% of that bond position is held simply to offset the worst 3 years of equity returns. With 10-year Treasuries yielding only 2.8%, the cost of re-allocating this 20% of the portfolio from stocks to bonds just to protect against market crashes is significant.
This is why we advocate using tactical asset allocation as a pivot around a strategic asset allocation core. Let’s continue to use the 55/45 stock/bond blend as a starting point. We can take 30% of the portfolio and put it into a tactical strategy that has the flexibility to move between 100% stocks and 100% bonds. We fund this allocation by taking half of the capital (15%) from stocks and the other half from bonds. Now our portfolio has 40% in stocks, 30% in bonds, and 30% in tactical. When the market is trending upwards, the tactical strategy will likely be fully invested and the entire portfolio will be tilted 70/30 towards stocks, taking advantage of the equity market tailwinds. When trends turn negative, the tactical strategy will re-allocate towards bonds and in the most extreme configuration tilt the entire portfolio to a 40/60 stock/bond mix.
In this manner, we can use a dynamic strategy to dial the overall portfolio’s risk up and down as market risk ebbs and flows.
For most investors, failure means not meeting one’s financial objectives. In the portfolio management context, failure comes in two flavors: slow failure results from taking too little risk and fast failure results from taking too much risk.
While slow failure has typically resulted from allocating too conservatively or holding excessive cash balances, the current low return environment means that even investors doing everything by the book may not be able to achieve the growth necessary to meet their goals.
Fast failure, on the other hand, is always a reality for investors. Market crashes will happen eventually. The biggest risk for investors is that they are unlucky enough to experience a market crash at the wrong time. We call this sequence risk.
A robust risk management strategy should seek to manage the risk of both slow failure and fast failure. This means not simply seeking to minimize risk, but rather calibrating it to both the objective and the market environment.
 Using Research Affiliates’ asset allocation tool, the efficient portfolio that delivers an expected real return of 4% means taking on estimated annualized volatility of 12%. This portfolio has more than double the volatility of a 40% U.S. large-cap / 60% intermediate Treasuries portfolio, which not coincidently returned 4% after inflation going back to the 1920s.
 The exact allocations are 0.5% U.S. small-cap, 14.1% foreign developed equities, 24.6% emerging market equities, 12.0% long-term Treasuries, 5.0% intermediate-term Treasuries, 0.8% high yield, 4.5% bank loans, 2.5% emerging market bonds (USD), 8.1% emerging market bonds (local currency), 4.4% emerging market currencies, 3.2% REITs, 8.6% U.S. commercial real estate, 4.2% commodities, and 7.5% private equity.
 Obviously, there are scenarios where large losses alone can be devastating. One example are losses that are permanent or take an investment’s value to zero or negative (e.g. investments that use leverage). Another are large losses that occur in portfolios that are meant to fund short-term objectives/liabilities.
 We assume 4% withdrawals increased for 2% annual inflation.