What is an Indexed Annuity?
In recent conversations with current and potential clients, we have seen an uptick in the use of indexed annuities as a tool for risk management.
For the uninitiated, Fidelity succinctly described an indexed annuity in a recent blog post:
“An indexed annuity is a contract issued and guaranteed by an insurance company. You invest an amount of money (premium) in return for protection against down markets; the potential for some investment growth, linked to an index (e.g., the S&P 500® Index); and, in some cases, a guaranteed level of lifetime income through optional riders.”
The rules that govern the performance credited to an indexed annuity account tend to be relatively simple and intuitive. A hypothetical example would be something like this:
- If the S&P 500 loses value over the policy year, the account is credited 0%.
- If the S&P 500 gains between 0% and 5% over the policy year, the policy is credited with the S&P 500’s gain.
- If the S&P 500 gains more than 5% over the policy year, the policy is credited with 5%.
In this example, the 5% figure is referred to as the “cap.”
While these rules may be simple and intuitive, the trade-offs inherent in such a contract are less clear.
Recently, I’ve been stealing the following phrase from my co-PM, Corey, quite frequently: “Risk cannot be destroyed, it can only be transformed.” I think this concept is especially applicable to indexed annuities.
Fortunately, indexed annuity-like payoff structures can be created with stocks, bonds, and options. By evaluating these replicating portfolios, we can start to develop a more complete cost/benefit analysis and perhaps better understand how these types of products may or may not fit into certain client portfolios.
For those not interested in the details, the takeaways are quite simple:
- Indexed annuities depend on interest income to finance investments in the equity markets.
- When interest rates are low, there is little capital available to make these equity investments.
- Limited capital means either (i) low equity participation rates or (ii) low caps that restrict potential upside.
- Low participation rates and/or low caps on index participation are a recipe for muted returns, which may make it difficult to stay ahead of inflation.
In short, indexed annuities suffer from many of the same problems that plague traditional asset classes in low interest rate and high valuation environments.
Example #1: Stocks and Bonds
Say we have $1,000,000 to invest. We want to invest it for ten years. We’d like some equity upside, but want to guarantee that we will get back our $1,000,000 at maturity. How might we go about doing this?
It’s not all that complicated. We just need to make two investments.
- Buy a Treasury STRIP that matures 10 years from today with face value of $1,000,000. Today, this would cost approximately $834,000.
- Invest the remaining $166,000 in the S&P 500 (or any other equity strategy).
10 years from now, the Treasury STRIP will be worth $1,000,000. As a result, we will breakeven even if we lose our entire equity investment. If equities end the period flat, we will have $1,166,000 – an annualized return of 1.55%. If equities appreciate over the next decade, our return will exceed 1.55%. The chart below plots the annualized portfolio return for various S&P 500 scenarios.
So where is the risk?
The portfolio consists of a 83.4% allocation to a zero-coupon Treasury bond and a 16.6% allocation to equities. For those familiar with indexed annuity lingo, this 16.6% is the participation rate. This is essentially a very conservative asset allocation model. It may be low risk, but it is certainly not risk-free despite the fact that the portfolio will be worth at least the minimum $1,000,000 in 10 years.
First, the value of the account can dip below $1,000,000 prior to maturity. Suppose that over the next year interest rates are unchanged and equities crash 50%. The account value will be $932,277, a 6.8% loss. On a side note, I actually think this may be one of the key benefits of an indexed annuity product: helping investors maintain a more optimal investment horizon by masking over short-term fluctuations.
Second, the go-forward appeal of this strategy will be highly dependent on interest rates. Higher interest rates will make the strategy relatively more attractive. Why?
Higher interest rates –> Lower STRIP prices –> More money to invest in equities
If 10-year STRIP rates were 5.00% instead of 1.83%, the STRIP would only cost approximately $614,000, leaving a $386,000 to invest in equities. Now instead of a 16.6%/83.4% stock/bond split, we get a 38.6%/61.4% split while still taking no risk of a 10-year loss.
Below, we plot what our hypothetical indexed annuity replicating portfolio would have looked like historically over different interest rate regimes.
Unsurprisingly, the performance of the hypothetical indexed annuity tends to lag in strong equity markets and shine when equity markets crash. That being said, the simulated performance is quite compelling on a risk-adjusted-basis.
The picture changes, however, when we re-run the historical simulations using today’s interest rates. The average annual return drag increases from just 1.05% with historical rates to a whopping 6.40% with current rates. 6.40% of drag vs. equities is especially problematic once we factor in low expected equity returns and inflation. While the risk of capital loss may be effectively mitigated, we have just substituted it for the risk that we fail to meet our growth objectives.
Once again, risk cannot be destroyed, it can just be transformed.
Indexed annuities are not immune from the low interest rate malaise currently gripping the markets.
I think it’s also important to consider the appropriate benchmark for this type of investment. In my view, ending the 10-year period with $1,000,000 is not “breaking even.” In our initial example, we could have avoided equities entirely and used all of our capital to buy a Treasury STRIP. Today, our $1,000,000 could purchase approximately $1,199,000 notional of these bonds. In other words, if we stick to our 10-year investment horizon, then we can guarantee that our account is worth $1,199,000 10 years down the road. This equates to a 1.83% annualized return. This is our benchmark.
When we plot the simulated performance (assuming today’s interest rates) vs. this breakeven benchmark, we see that performance did in fact slip below 1.83% for investor’s that initiated their investment between October 1998 and January 2001. These investors would have struggled because they experienced both the popping of the tech bubble and the global financial crisis. Lo and behold, risk exists. In essence, the replicated indexed annuity is investing the future interest to be earned on the STRIP investment in equities. If this investment isn’t profitable, the investor would have been better off sticking the Treasuries.
Example #2: Options and Bonds
One way we can deal with the low equity participation rates caused by low interest rates from our first example is to introduce leverage. Specifically, we can do so by using equity index options.
Again assume that we have $1,000,000 to invest for ten years. We still want to impose a $1,000,000 floor on our account value at the end of the period, but now we want 100% participation with equity gains (at least up to some cap).
How would we go about doing this?
We start by buying $1,000,000 of 10-year Treasury notes at par. Today, the interest rate on this investment would be 1.88%. Treasury bonds pay interest semi-annually and so the investment will generate $9,400 in interest payments every six months.
To get our equity participation, we will use this cash flow to buy at-the-money call options on SPY that expire in six months. Let’s say each of these options costs $10, so we can buy 940 options. This is problematic. We want 100% participation in equity gains. To get this at SPY’s current price of around $206, we need to buy 4,854 options ($1,000,000 divided by $206).
940 options gives us a participation rate of less than 20%, not too much different than our portfolio in Example #1 above.
Fortunately, we can solve our issue with a bit of financial engineering. Say that call options with the same expiry and a strike of $209 (about 1.5% out-of-the-money) are trading at $8. If we sell one of these options for each $206 strike call we buy, we have created a bullish call spread. These call spreads only cost $2 each, allowing us to buy the 4,854 units we need.
We now get 100% participation in equity gains. However, we have paid a price for this. Namely, we only get 100% participation for gains up to 1.5%. We have sold the rights to any gains in excess of 1.5% in order to finance our call purchases. We have “capped” our six equity return at 1.5%.
At the end of six months, we will re-invest any option payoffs into Treasury notes/bills. As a result, we may have slightly more than $9,400 to buy options for the next six-month period.
We continue this process for ten years (or 20 six-month periods). Even if the worst case scenario plays out and the market goes down each and every period, we will still receive our $1,000,000 principal back from the 10-year Treasury note investment.
Below, we again simulate how such an approach would have hypothetically performed relative to the S&P 500.
When we use historical interest rates, the results are once again pretty compelling. On average, the simulated indexed annuity trails the S&P 500 by less 1% per year, while providing nice downside protection.
Unfortunately, when we repeat the simulation using today’s interest rates, we see that this simulation has the same shortcomings as our first one.
When interest rates are low, our Treasury bond position throws off very little cash. With low cash flow, we aren’t able to buy very many at-the-money call options. As a result, we need to sell calls with strikes that are quite close to today’s equity prices in order to finance our at-the-money call purchases. This effectively sets our cap very low and puts strict limits on how much equity upside can be realized. The annualized drag to the equity markets is now nearly 5% per year.
Once again, risk has not been eliminated. Our “reward” for buying the Treasury bond is the interest payments. We use these interest payments to get leveraged market exposure through options. If the market declines, the options will expire worthless and we have lost our interest payments.
The commonsense benchmark for this portfolio is just a 10-year Treasury bond. The 3/31/16 rate that was used in the simulation was 1.78%. This 1.78% is our benchmark. We see below that the simulated indexed annuity barely beats out this benchmark in most cases.
A Word About Dividends
Research Affiliates estimates that U.S. large-cap equities have a 10-year expected return of 1.3% after inflation. On a nominal basis – or adding back in inflation of 2.0% – this number becomes 3.3%. Of this 3.3%, they believe that inflation will contribute +2.0%, dividends will contribute 2.2%, and growth will contribute 1.3%. But, this adds up to 5.5%. What gives? Research Affiliates believes that equity valuations will gradually revert back to historical norms. They estimate that this will be a 2.2% annualized drag on performance.
As you can see, dividends are a crucial part of equity returns. If we remove the 2.2% dividend yield, the above expected return number drops from an already meager 3.3% to only 1.1%.
This is problematic for indexed annuity investors, since credits are often based on price, not total, return of the equity index.
To test the impact of this, we can perform some Monte Carlo simulations using the Research Affiliates capital market assumptions. We compare a 20/80 S&P 500/Barclays Aggregate portfolio to the following indexed annuity (note: we took this structure from a popular product in today’s market):
- 4% bonus on initial investment
- 100% participation rate on S&P 500 with a cap of 2.5%
- S&P 500 return is measured using the annual, point-to-point methodology (i.e. we compute the return using just the beginning of year and end of year S&P 500 values)
We performed 10,000 simulations of 10-year periods. The following histogram plots the annualized out/underperformance of the 20/80 portfolio vs. the indexed annuity over 10-year periods. Positive numbers mean the 20/80 portfolio outperformed. Negative numbers mean the indexed annuity outperformed. All returns are annualized.
On average, the 20/80 returned 3.45% per year over a 10-year period. The indexed annuity returned 1.89% per year. The 20/80 portfolio beat the indexed annuity in 88.8% of the simulations.
Indexed annuity proponents may point to the risk management benefits of the product in trying to reconcile these statistics. There are a few problems with this argument.
First, the 20/80 portfolio isn’t all that risky to begin with. It only lost money over 10-years in 1.1% of the simulations. And this is using today’s capital market assumptions where both U.S. stocks and bonds are overvalued and therefore offer low future expected returns.
Second, and much more importantly, we have to consider inflation. To see why, consider the simplest form of risk management, holding cash. This will guarantee that you protect your capital, until you wake up a decade later only to realize that inflation has eroded your purchasing power.
If we deduct 2.0% of inflation per year, the “risk management” scoreboard changes dramatically. The 20/80 loses money on an inflation-adjusted basis in 15.9% of the simulations, while the annuity fails to keep up with inflation 59.9% of the time! In our experiment, you are more likely to lose money than make money with the annuity over a decade. Hardly risk-free!
Conclusion
Risk cannot be destroyed, it can only be transformed. Warren Buffett famously said, “If you’ve been playing poker for half an hour and still don’t know who the patsy is, you’re the patsy.” The same idea holds true with any financial product. There is always risk somewhere. If someone selling a product says otherwise, then be very, very suspicious.
For indexed annuities, the main risk is that potential returns are severely limited when interest rates are as low as they are now. High interest rates are the fuel that may allow these products to deliver equity-like returns with less downside risk. Without high interest rates, however, you are going nowhere fast. Going nowhere fast is a problem when inflation is always nipping at your heels. Downside risk management is great, until it restricts your growth so much that your purchasing power erodes over time.
Data Sources and Disclosures
Data comes from the Federal Reserve, Research Affiliates, CBOE, and Morningstar. Calculations were performed by Newfound Research.
Index annuity guarantees are subject to the credit of the issuing insurance company.
All returns are hypothetical and backtested and reflect unmanaged index returns. Returns do not reflect fees. Past performance does not guarantee future results. Results are not indicative of any Newfound index or strategy. Hypothetical performance results have many inherent limitations and are not indicative of results that any investor actually attained. An investor cannot invest directly in an index. Index returns are unmanaged and do not reflect fees and expenses.
For the options analysis, we use historical VIX levels with a 20% premium applied to reflect the higher implied volatility typically associated with longer-term options.
Failing Slow, Failing Fast, and Failing Very Fast
By Justin Sibears
On April 9, 2018
In Risk Management, Sequence Risk, Weekly Commentary
This post is available as a PDF download here.
Summary
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.”
Failing Slow
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.
Data Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html. Calculations by Newfound Research. Past performance does not guarantee future results.
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.
Data Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html. Calculations by Newfound Research. Past performance does not guarantee future results.
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.
Expected return forecasts are the views of the listed firms, are uncertain, and should not be considered investment advice. Nominal returns are adjusted by subtracting 2.2% assumed inflation.
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[1]. 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[2].
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[3][4] and what can be done about it[5][6].
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.
Failing Fast
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[7]. 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:
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[8]. 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:
Data Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html. Calculations by Newfound Research. Past performance does not guarantee future results.
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).
Data Source: CSI, Salient. Calculations by Newfound Research. Past performance does not guarantee future results. Returns include no fees except underlying ETF fees. Returns include the reinvestment of dividends.
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.
Data Source: CSI, Salient. Calculations by Newfound Research. Past performance does not guarantee future results. Returns include no fees except underlying ETF fees. Returns include the reinvestment of dividends.
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:
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:
On that last point, the benefits of diversifying your diversifiers cannot be overstated.
For example, take the following four common risk management techniques:
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.
Data Source: CSI, Salient, Bloomberg. Calculations by Newfound Research. Past performance does not guarantee future results. Returns include no fees except underlying ETF fees. Returns include the reinvestment of dividends. Blend is an equal-weight portfolio of the four strategies that is rebalanced on a monthly basis.
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[9] (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.
Summary
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.
[1] 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.
[2] 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.
[3] https://blog.thinknewfound.com/2017/08/impact-high-equity-valuations-safe-retirement-withdrawal-rates/
[4] https://blog.thinknewfound.com/2017/09/butterfly-effect-retirement-planning/
[5] https://blog.thinknewfound.com/2017/09/addressing-low-return-forecasts-retirement-tactical-allocation/
[6] https://blog.thinknewfound.com/2017/12/no-silver-bullets-8-ideas-financial-planning-low-return-environment/
[7] 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.
[8] We assume 4% withdrawals increased for 2% annual inflation.
[9] https://blog.thinknewfound.com/2015/09/achieving-risk-ignition/