MEASURE AND CONTROL RISK

I. Establish Risk Tolerance Level

The first principle we follow at Secure Retirement involves risk control. The principle, simply stated, is that we want our portfolios to withstand every possible difficult economic time period without ever losing a penny more than you are comfortable losing. Risk must be carefully and precisely calculated in order to insure that you will never suffer unacceptable losses. This goal is achievable, if investors have and follow a sound discipline.

How do you create a portfolio that has the right risk level for you?

We begin by finding your personal risk tolerance level. Our goal is your peace of mind, and in order to achieve this goal, we need to know what would disturb your peace of mind. Would you become upset if you lost 10% of your money, 20%, none? On one hand this is a personal decision. Some people can tolerate more risk before becoming uncomfortable. They have consciously, and hopefully emotionally, accepted that they could lose larger amounts.

Generally, risk tolerance goes down with age
In our experience, we have found that investors often get wiser as they mature. They know they don’t have time to recoup serious losses. And they aren’t interested in spending their time worrying about losing money. This is particularly true if they have enough money to live just the way they want without taking much, if any, risk in their investments.

However, these days many of our clients are retiring earlier, and living longer
Portfolios with longer time horizons may need to assume somewhat more risk in order to keep up with inflation, and the probability of serious risk occurring is much higher over a longer time period. Proper risk control is therefore absolutely essential for this group of investors

Risk tolerance is ultimately an inner emotional fact, but it should also be tied to our external financial state
In order to determine how much risk you should take based on your finances, we need to make a retirement plan for a client. Once we have created this plan, you can then see what the numbers tell us you could, or could not, afford to lose before you will and should feel uncomfortable. We then compare the risk tolerance level you believe you have with the risk level that is appropriate based on your external financial situation. Together, we then select the amount below which you absolutely never want your portfolio to fall.

Establishing your risk tolerance level tells us how to construct your portfolio

Once we know your risk tolerance level, we then construct a portfolio that has the highest probability of never falling below your comfort level – up to the 99.9% probability level. This means you will never lose a penny more than you are comfortable losing, unless we have the worst year you would expect in 1000 years. That is risk control.

When people look at their investment temperament and external financial condition in retirement, most people will choose a lower range of -15, -10, -5, or 0% as the most their portfolio could go down. Most people are comfortable with those numbers as the worst-case scenario for their investments at the 99% probability level. We know many people, typically when they first retire, who think they could lose 20% or more of their retirement funds. To date, however, we have never met a retired person who lost 20% of his or her money who was not upset about this fact.

II. Portfolio Construction & Implementation

Each of the following steps is essential to control risk in every investment portfolio, and when combined properly allow us to create a portfolio that not only accurately mirrors your individual risk tolerance level but is actually substantially safer, providing an additional “cushion” of safety.

Efficient Set Theory

We begin the portfolio construction process by using Efficient Set Theory in order to set the absolute worst-case risk “barrier” below which our portfolios will not go. This involves three steps. We then add two additional “layers” of risk control into the system to reduce risk further:

1. Mathematically measure the risk in every asset class.
2. Calculate the correlation between every asset class.
3. Implement Efficient Set Theory

Data on the risk level of each asset class, their expected returns, and the correlations between them are input into a program that has the precise equations from Dr. Markowitz’s Efficient Set Theory in them. This program then shows us the combination of assets that has the highest expected return at each risk level. This forms what is called the “efficient frontier of optimum portfolios,” which simply means all the portfolios with the highest expected return at each risk level. (Expected returns, correlations, and the standard deviations of all asset classes used in the calculations in this report are based on historical data from 1/81 through 6/06.)

In order to understand what all this means, in the next section, “Model Portfolios,” we will look at the actual risk levels of portfolios people commonly choose for their retirement funds.

Additional Methods of Risk Reduction

Security Selection

This topic is covered in detail below from the standpoint of achieving higher returns, but it is also an essential step from a risk control standpoint. Until now we have only been considering the risk from an overall portfolio level, and we have been looking at the risk of entire asset classes or indexes.

However, we do not invest in index funds that replicate entire asset classes. Instead, we select individual funds in each asset class. These funds have earned substantially more than their indexes, with less risk.

For example, many of our funds actually made money during 2001-2002. Each fund manager we use is an expert at selecting stocks or bonds that have a high probability of holding their value in a serious market downturn. Some have been so successful over such a long time period that we would probably be justified in using their low risk scores in our analysis. Instead, we use the fact that our funds are much safer than their indexes to provide an additional “buffer” against risk. Whatever our overall portfolio risk score indicates, our fund managers are working to lower that level further – in many cases much further.

Avoid Mistakes

The final essential step to controlling investment risk is the most difficult. Investor mistakes lead to more losses than the markets themselves, and the average investor actually earns far less than the markets. You should have a proven, comprehensive investment discipline in place. This discipline should be kept clearly in mind whenever making an investment decision.