Risk Control
By Richard Morey

At Secure Retirement we use three interlocking methods to control risk. The first involves determining how much of a portfolio to have in fixed income investments, which include many types of bonds and, in certain cases, fixed annuities. The second risk control measure shows how to minimize losses in the stock market. The final approach we use is called "catastrophic risk control." All three methods are used together in an “interlocking” fashion.

I. Asset Allocation, or Determining How Much to Have in Fixed Income

A. There are three ways to determine this. A simplified but very effective method was taught by Benjamin Graham at Columbia’s Graduate School of Business. Mr. Graham recommended that a person have from 25% to 75% of their retirement money in fixed income investments, based upon the individual’s tolerance to risk, age, and financial circumstances. At Secure Retirement, nearly all our portfolios fall within this range. And as is appropriate, our older and more conservative clients typically have the largest amounts in fixed income.

The only changes Mr. Graham recommended were primarily for more adventurous investors. He recommended that they reduce their fixed income investments, putting additional money into stocks whenever the stock market was low, and that they reduce their stock market exposure whenever it became expensive (always keeping within the 75%/25% boundaries for retirement money). In other words, buy more stocks when they are low-priced and sell some when they are high-priced.

Understanding that many investors are not able to exercise the discipline of proactively buying low and selling high, he recommended they select the right amount in fixed income and stick to it. It is usually better for older investors to select a conservative allocation at the beginning and keep it conservative, as doing so protects against the catastrophic risks discussed later.

B. The second way to decide how much to have in fixed income versus more volatile investments is to use "Efficient Set Theory" or a similar mathematically-based program to calculate the risk level in a portfolio. This is the approach used to attempt to control risk in much of the investment industry at this time. Unfortunately, it tends to “break down” during times of extreme economic disruption, i.e. times when fear and uncertainty grip the market and it plummets. However, these are the times when risk control is needed the most.

That being said, mathematically-based approaches to risk control can be useful, when used as one part of a multi-pronged risk control program.

C. Perhaps the oldest and most simple way to determine how much of your retirement money should be protected is to subtract your current age from 100. The resulting number then becomes the percentage you should invest in stock funds, with the remainder going to fixed income. In other words, your current age is the percentage you would have in fixed-income. While very simple, this method actually works quite well for many investors.

II. How to Avoid Stock Market Risk

A few years ago Warren Buffett made a most remarkable statement. He stated that, if you buy the stock of truly great companies at low prices and keep them for years, your stock investments are essentially risk-free. This is why Mr. Buffett sometimes scoffs at the mathematical methods to calculate risk. He knows that, if our discipline is followed properly for years, the risk we are attempting to calculate and control will never materialize.

But this only works on a long-term basis. Retired investors are also concerned about shorter-term risk control. As a result, we include the fixed income allocations in order to reduce short-term risk.

If you look at the history of the stock fund managers we use, we believe you will find they have been some of the safest stock investors in history. Combined with our superb, safe fixed-income investments, our “standard” portfolios are, we believe, substantially safer than the vast majority of retirement portfolios.

III. Catastrophic Risk Control

The final level of risk control involves studying macroeconomics to spot large potential economic disturbances and provide protection against them. Whenever a large economic danger is on the horizon, we study it intensively and, when warranted, make the investments needed to protect our portfolios from this risk.

Sometimes we simply want to get out of the way of the fallout from macroeconomic imbalances. An example of this type of risk includes the residential real estate, mortgage and banking meltdowns of 2008-2009. In this case, we saw these risks coming clearly in advance and worked to minimize the losses that followed. This was achieved by selling our most volatile stock funds before the market crashed.

Difficult markets and economic time periods are often preceded by exuberance. As the public is certain the off-balanced markets will continue to go up, we want to begin selling when clouds are on the horizon. We can then return later to pick up the valuable pieces. Acting accordingly removes one other catastrophic risk to a retirement portfolio, which is caused by investing in bubbles.

In addition to minimizing losses during a stock market crash, this appoach also helps us avoid another huge investment risk. This involves investing in markets that have become “bubbles.” At Secure Retirement, whenever any market has become a bubble, we exit that market. We believe all investors would be wise to follow this approach. “Selling high” makes you money, while continuing to own severely overpriced stocks always ends poorly, i.e. in large losses.

Summary