Risk Control
By RIchard Morey
September 6, 2008

We use three interlocking methods to control risk. The first involves determining how much of a portfolio to have in fixed income investments, which includes bonds, fixed annuities, and Certificates of Deposit. 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.

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 money in fixed income investments, based upon their 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. This proactive approach is particularly valuable for younger investors.

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 control risk throughout 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!

Still, 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 most investors.

II. How to Avoid Stock Market Risk

Last summer Warren Buffett made a most remarkable statement. He stated that, if you buy the stock of 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 goes away.

Of course, this is only true on a long-term basis. However, retired investors are also concerned about shorter-term risk control. As a result, we must work with fixed income allocations in order to reduce risk - even if, as we expect, we never have long-term stock market risk.

But the reduction - or elimination - of stock market risk that Mr. Buffett has achieved over the last 50+ years does lower the risk level of our portfolios dramatically. When owned properly, over time our largest stock fund holdings may be safer than cash. This is particularly true during inflationary times, or whenever the value of the dollar is diminishing.

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 recent residential real estate, mortgage and banking meltdowns. 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 other cases avoiding large macroeconomic risks is not a possibility. Inflation is a good example. It is hard to avoid inflation, as it impacts nearly every aspect of an economy. To protect against these types of risks, special investments are sometimes needed to proactively protect our retirement accounts.

Summary

We use asset allocation to measure and control overall portfolio risk. When combined with the best stock-based investments, owned following our discipline, "ordinary" stock market-related risks are recognized, reduced and/or eliminated. Severe, extraordinary risks are then accounted for and protected against through our catastrophic risk control methods. When combined, your retirement portfolio will be created at the right risk level for you, and then managed to make sure you never experience risk beyond your tolerance level. The result is a "smoother," more comfortable investment experience - and substantially higher long-term returns.