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Risk
Control
By Richard Morey, September 6, 2008
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We use three levels of risk control. The first involves determining
how much of a portfolio to have in fixed income, while the second shows how to avoid losses in the
stock market. The final approach we use is called “catastrophic risk control.” All
three methods are used together, at all times.
I. Asset Allocation, or Determining How Much to Have in
Fixed Income
a. There are two ways to determine this. A simplified,
but very effective, method was taught by Benjamin
Graham, the teacher of Mr. Buffett, Mr. Berkowitz, and
me. 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
larger amounts in fixed income.
This method is very simple, and it works. At Secure Retirement,
our most conservative investment portfolios
have still managed to make over 4% over the last year (ending
8/29/08), during which time the stock market has lost 12%.
Of course, those who have more invested in stocks will
have more short-term risk, but they should also have substantially higher long-term returns.
The only changes Mr. Graham recommended were primarily
for the 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).
Understanding that many investors are not able to exercise
this discipline, or do not want to if they are more
conservative investors, he recommended they select the
right amount in fixed income and stick to it. At Secure Retirement, we can manage retirement portfolios
in either manner – both work quite well.
The second approach is, however, more appropriate for younger
investors. 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
something called “efficient set theory” or
a similar mathematically-based program to calculate the risk level in a portfolio. The best way is to calculate
the risk at the 99% and 99.9% probability levels.
The 99.9% level means that a portfolio should not go beyond
the boundaries more than one out of every 1,000 years. That’s a very stringent risk level.
At Secure Retirement, our most aggressive growth portfolios
could go down 19% at the 99% probability
level and 28% at the 99.9% level. Our conservative portfolios
could go down 7% at the 99% level and 9% at the 99.9 probability level.
While we do these calculations to see the absolute worst-case
scenario that could occur, we are confident
our other methods of risk control eliminate the types of
risks that can lead to losses at the 99.9%
probability level. We therefore make a commitment to our
clients that their portfolios will never touch the lower 99% probability level for any entire year.
Of course, while we are absolutely serious about making
sure none of our portfolios ever touch the 99%
risk level, we also know that the probability of risk goes
down over time – dramatically – over even
a two to three year time period. This leads us to the next
level of risk control, in which we basically
attempt to not only calculate and control but actually
eliminate much of the risk of stock market investing.
II. How to Avoid Stock Market Risk
Last month I heard Warren Buffett make the most remarkable
statement. He stated simply that, if you buy
the stock of great companies at low prices and keep them
for years, your investments are
essentially risk-free. This is why Mr. Buffett sometimes
scoffs at some of the ideas presented above.
He knows that, if our discipline is followed properly,
the risk we are attempting to calculate goes away.
As a result, he recommends a person keep their eye on following
the discipline and not worry about the math! While
I basically agree, I also know that Mr. Buffett does not
manage retirement portfolios, as his teacher
did and I do. As a result, I must work with fixed income
allocations in order to reduce risk– even if, as I expect, we never have long-term stock market
risk. Retirement investing involves risk
control beyond what even Mr. Buffett is required to do,
as it is more like a sacred trust than a business arrangement.
Being the leading professor of his day on retirement investing,
our teacher Benjamin Graham knew this and focused, as I do, on fixed income
investing along with stocks and stock funds.
But the reduction – or elimination – of stock
market risk that Mr. Buffett has achieved over the last
43 years lowers the risk level of
our portfolios, I believe, more than the work I do on the
fixed income side of our portfolios.
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
our cash 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 downfall
that follows macroeconomic imbalances.
An example of this type of risk would include the recent
residential real estate, mortgage and
banking problems. In this case, we saw it coming clearly,
very early on, and have worked to avoid the major risks these sectors are delivering to our economy
right now.
In other cases simply 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. 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 exiting when the
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 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.
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