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September 21, 2015

Risk Part Three

Conversations about risk are complicated and the most important risk is the possibility of not meeting your financial goals. Managing this risk is the essence of what financial planners must provide for retirees. That focus drives decisions in financial planning, tax planning, investment planning and Social Security planning. Individuals are probably most familiar with managing risk in investment planning. There are three steps that we take as advisors to control risk for investors in retirement.

  1. Decide on an appropriate risk level for the unique situation
  2. Avoid overpriced or very expensive investments
  3. Allocate the risk budget over time

Decide on an appropriate risk level for the unique situation

We work to determine the risk tolerance, risk capacity and risk required for each client’s situation. Remember both risk tolerance and risk capacity need to be higher than the risk required to meet a client’s goals. If that isn’t the case, we help our client with adjustments. Sometimes the client’s goals need to be reconsidered and lowered.  Other times we find that by making adjustments to future plans, we can align the goals and reduce the risk required. It is more difficult to adjust risk tolerance, but ongoing education can increase risk tolerance over time.

In the end we need to agree with the client on an overall risk level. Frequently it comes down to two simple questions:

  • If the market goes up 20% next year how much do you expect your investments to go up in value?

And

  • If the market goes down 20% next year how much do you expect your investments to go down in value?

These questions seem easy and most people have reasonable responses. The questions are a good way to discuss risk tolerance, but are really an oversimplification of what happens during any given year. Markets don’t all move together and the accounts we manage are diversified and not solely invested in U.S. stocks and cash. Over time that should improve returns at a given risk level. However, some years owning international stocks or bonds might detract from other returns. Many investors don’t realize that they can lose money in bonds. Bond markets move as well, and over short periods of time the returns in bond markets can affect an account. In 2013, 2014 and in the first half of 2015, a simple account of U.S. stocks and U.S. government bonds would have outperformed a more diversified account. A long streak like that is unusual, but during 2003 – 2007 there was a long streak of outperformance in more diversified portfolios.

Deciding on an appropriate level of risk is perhaps the most important part of a new client relationship for an investment manager. Getting it wrong almost always dooms the relationship and sometimes it can take years to realize it was wrong.

Avoid overpriced or very expensive investments

The more expensive something is the greater the risk of losing money. Suppose you are buying a house that you plan to own for five years. The more you pay for the house the more likely you are to lose money on the house. By buying something at a decent price, you reduce the risk that you will lose money on the investment. The same is true of all investments. Price matters and higher prices mean higher risk.

You may hear us talk about fair value, which is what we think something is really worth. Let’s go back to the house example. Let’s say I think the house I am looking at is worth $150,000, but it is selling for $130,000. That is $20,000 under fair value. That $20,000 creates what we call a margin of safety. It doesn’t mean that we can’t lose money, but it does mean if the housing market gets worse we shouldn’t lose as much.

There are many ways that we can analyze the value of an investment. For stocks we will generally refer to the P/E ratio. That is the price per share divided by the earnings per share. When you read about P/E ratios you want to understand what earnings someone is using in the calculation. Is it what the company earned last year, next year or an average of the last 10 years?

We look at earnings and cash flow ratios to determine what we believe is the fair value of a stock, a market, a sector, a bond or any investment.

Allocate the risk budget over time

Risk budgeting is an ongoing process to reassess and control the total risk in a portfolio over time. Let’s say that the goal is for a portfolio to have half the risk of the stock market over time. We call this an income and growth account, balanced account or simply a 50/50 account.  There are many ways that I could divide up taking half the risk of the equity market and half the risk of the bond market. If I use riskier bonds, such as high yield bonds, I may need to own fewer stocks to offset the additional risk. If I own very conservative stocks, I may be able to own slightly more than 50% stocks.

We also consider the fair value as part of this risk budget. When stocks look expensive and therefore have higher risk, we tend to own fewer of them. Recently we have believed that high quality bonds look very expensive. Therefore, we try to own fewer of these bonds and move that money to lower risk strategies. The risk in the individual investments changes over time and needs to be monitored. Some investment advisors use quarterly or annual rebalancing to diffuse risk over time. We are often asked how often we rebalance. We actually work to manage this risk budget on an ongoing basis rather than simply rebalancing once per quarter or year. My Dad says, “The time to rebalance is when you are out of balance. It has nothing to do with the calendar.”

Bottom Line: Risk management is a challenging, ongoing process that every retirement plan must address.

From the desk of Kris Carroll

Retirement Income, Risk

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