Chapter 2 – Understanding Risk and Asset Allocation

Chapter 2.

Understanding Risk and Asset Allocation

Asset allocation (AA) is a financial term that simply refers to what percentage of money you decide to put into stocks, bonds and cash—the primary asset classes. The purpose is to set the amount of risk you should be taking. It’s sounds simple, but the results say it’s not. It is the most significant decision regarding risk and potential returns you can make, but far too many investors choose to be overly aggressive (although they don’t realize it) and they end up bailing out near the bottom of a severe loss, meaning they got it wrong.

Defining Risk
The financial world defines risk as randomness with knowable probabilities that can be defined and calculated. But, there is another form of risk that we as investors need to understand, and that isn’t even called risk. It is called uncertainty. Uncertainty is risk with unknowable probabilities. It can’t be measured or calculated. As financial advisor Carl Richards says: It is the risk that is left when we have covered everything we do know about. Or, more to the point: It’s the other risk, stupid.

Unknowable probabilities occur very infrequently but have devastating consequences. Hurricane Katrina is an example. Several years after Katrina, the mayor of New Orleans said he should have evacuated the entire city. Why didn’t he? Because the power and destruction Katrina unleashed was off the chart and there was nothing in memory for comparison. In other words, it was unimaginable. In the financial world, we must live with a certain element of the unimaginable.

An example of risk aversion misplaced
In 2011 we are concerned about bond fund losses due to inflation. We know that interest rates have nowhere to go but up, and we know what will happen with bonds funds when rates rise–they will lose money. We also know how much–they will lose the amount of their duration for each 1% rise in rates. This risk is easy to see and calculate: it has knowable probabilities, and yet investors are moving out of bonds for fear of loss, and some are even moving into equities as an alternative. Furthermore, bond fund losses recover relatively quickly because of the increase in yield. So, much of the fear is over done, and certainly it is not rational to move into the higher unknowable probabilities of stocks as a less risky alternative because stocks might have 5 times or more loss potential than intermediate bonds. What’s going on is bond risk has come out of the shadows and can be easily seen, so investors do something to avoid a loss they know will happen. What they don’t seem to understand is stock loss, a far uglier creature, never comes out of the shadows, so it is not treated with the same fear. In fact stock market risk is a deceptive chameleon that may be most ignored at the most dangerous time.

I can present information that will help you with the knowable risks, but keep in mind that uncertainty and potential large losses always lurks in the shadows. There are a few different ways in which risk is defined, but here is as good a practical definition as there is: The risk of putting your money into stock investments is that it may be gone when you need it.

Asset Allocation and Risk
Extreme market disruptions occur much more frequently than the mathematics would predict. Severe bear markets should not occur as frequently as they do, and while the last three major Ones caused a drop of about 50% there is nothing to say we cannot see a much larger loss. Still in the memory of a few is the 90% drop in the great crash of 1929. What I’m trying to impress on you is it naive to assume the market will always provide wealth in the long run. Getting wiped out half way down the road isn’t going to get you there.

Many different approaches have been tried to connect risk with the very real pain of loss, but severe downturns continue to surprise investors and cause them to bail out and abandon their plan at the worst time. AND THEN they reduce their risk exposure. You don’t know how it feels to burn yourself with a match until you do it. Then you get a little more respect for lighting a match. I cannot convey the pain of getting burned nor can I convey the pain of losing a substantial amount of money—all I can do is warn you that for all but the extreme risk takers, it hurts more than you might realize. In some cases, it isn’t the loss that is disturbing, it is the feeling of loss of control.

The higher percentage of stocks you own, the higher your potential for big returns. But risk is a double-edged sword. Risk means in no uncertain terms that you might not achieve those big returns. The very fact that stock investing offers higher returns than safer investments can only mean there is higher risk of loss. Investing offers no guarantee, and there is no way to avoid the risk, and unlike the bond example, you aren’t going to get a clear sign for when the risk will show up.

Knowing this, smart investors always seek a good balance between risk and potential reward. In fact, balance and compromise is necessary in all investing decisions. Investing risk has two dimensions, one is loss frequency and the other is loss magnitude. If the experience of a worst case scenario is not stored in memory, there is a tendency to assume the frequency of a disastrous outcome is almost zero. However, the past 10 years has provided two real experiences with frequency. When looking at magnitude, maximum drawdown (loss) of an all equity portfolio is usually suggested to be 50% because this has been the maximum drawdown in any bear market since 1973-74. It’s occurred three times. Why do we assume that 50% is maximum? There is nothing at all to prevent deeper losses. In 1929 we experienced a 90% loss. And it took 22 years to fully recover! It happened, but it’s inconceivable by today’s standard because it isn’t in the memory bank. It hasn’t happened for so long, it won’t happen. Is it likely to happen again? No. Is it possible? Yes. The worst case scenario is often more consequential than any forecast can predict.

Of the two elements of frequency and magnitude, it is magnitude that causes the problems. Investors are naturally risk averse, but they don’t realize it until they are in the middle of a stressful situation. The pleasure of a $100 gain does not match the displeasure of losing $100. The pleasure of a $250,000 gain does not equal the pain of losing $250,000.

Before you make the decision about your asset allocation, you need to know what it is exactly you are trying to accomplish. To get maximum returns is not the right answer. You begin by defining your goals and the target amounts needed as best you can. Younger investors may have several goals they’re working toward such as retirement, college for the children, and a new home. Each of these goals has a different time frame and a different target amount of assets needed. And each requires a different asset allocation. The more you understand about risk, the more able you will be to make good decisions about your asset allocation and the more likely you will be to stick with your plan. Your decision should match your personal financial ability and emotional ability, and that’s why a good recommendation for one person may not work for another. Don’t compare your allocation to those of others, it isn’t relevant.
This link leads to a good article on risk by Peter Bernstein.
http://biz.yahoo.com/nytimes/080621/1194787217711.html?.v=1

Here is a good perspective on how risk should be approached by Zvi Bodie, professor of finance, and Paula Hogan, CFP, CFA.
http://www.aaii.com/features/jrnl200506p16.pdf

Emotional Temperament and Risk
New investors enter the arena with built-in biases. Recent studies have shown that how a person views risk is based on family background and lessons learned from their own experience unrelated to investing. These perceptions frequently result in newer investors overestimating their tolerance for risk. That has been clearly confirmed by the number of investors who abandon their asset allocation and bail out of stocks at the bottom of a bear market. Here is what Vanguard has to say: Our experience suggests that even long-term investors pay attention to short-term downside risks during the holding period. Furthermore, their real-time reaction to downside risk is much more significant than indicated prior to the realization of the downside risk.

So, how much of a loss is really going to keep you pacing the floor at night? How much of a loss is going to make you flinch?

What makes investors flinch?
1. Inexperienced investors move into defensive mode under stress and fall back on gut instinct, which quickly overrides the AA decision they made in good times.
2. Perception of risk is not constant. Risk may be perceived to be practically non-existent in good times and extremely high in times of market stress or personal emotional stress. If you have not been through a full market cycle, including a bear market, it will be very difficult for you to properly asses your reaction in times of real stress.
3. Choosing an asset allocation seems so simple to do that it’s often done without much planning. Most newer investors only focus on the allure of recent past returns which are right there to see. They downplay risk because it isn’t in sight. And that’s a point worth remembering— those times when you don’t perceive any real risk are actually more risky. Risk is all about surprises that can spoil the party.

So, what should you do? First, realize that your assumed tolerance level is likely to be lower under severe market conditions when it’s most important. Second, focus on your goals and your plan and set up asset allocations that match them. If you get that right, then you will find it easier to stick with your plan.

Risk Analysis Questionnaires
Some investors who talk with an advisor are given a risk analysis test. Others might be referred to web sites that have questionnaires designed to help choose an allocation. Don’t trust these questionnaires because what they really tend to do is confirm preconceived notions about your tolerance. They either ask you how much risk tolerance you have, for which you have no reference to determine, or they attempt to quantify your need for returns and then offer a portfolio without consideration for your emotional risk tolerance. Here is what William Droms, CFA, and Steven Strauss, CPA/PFS, had to say about questionnaires in an article in The Journal for Financial Planning titled “Assessing Risk Tolerance for Asset Allocation: “Virtually all experienced financial planners and investment managers would agree that a questionnaire by itself cannot possibly lead directly to a definitive asset allocation plan.”

The level of risk you choose should be based on factors including age, job type and security, marital status, contingency plans, and back-up resources. Then these factors have to be balanced against your emotional tolerance for risk. If your needs and abilities exceed your emotional tolerance, you are likely to dump your strategy at the worst possible time even though they were well analyzed. Notice I said the level of risk you choose. And that is exactly what you need to do. Do not select a portfolio based on the returns you choose. You can’t control returns–only risk. You may or may not get the returns you hoped for, but you always get the risk.

Basic Market Behavior and Risk
To help understand normal market risk, let’s look at typical market behavior. Here is what William Coaker, CFP, CIMA, says you will encounter in your investment journey: Investment professionals often tell clients, “I think the S&P 500 will be up 10 percent next year,” and clients like to hear that. But it almost never happens. From 1926 to 2004, the S&P 500 rose between 8 percent and 14 percent in only six years, an 8 percent occurrence. In fact, just 25 times in 79 years the S&P 500 returned between 0 percent and 20 percent, which is only 32 percent of the time. That means the index has been more than twice as likely to lose money or gain more than 20 percent than to experience returns between 0 percent and 20 percent.

The first thing to note is markets are volatile and you cannot expect things to go smoothly, nor can you rely on past behavior as a predictor of future behavior. We have seen fluctuations from the euphoria of “this time it’s different” to the despair of “the death of equities.” Normal markets are random and unpredictable in the shorter term. And contrary to popular belief, they are not less risky in the long term. You will lose money at times, no way around it.

Jack Duval, Registered Investment Advisor, has this to say in his article, The Myth of Time Diversification: the idea that the longer an investment is held, the less likely it is to produce a loss. It is an idea that enjoys wide circulation on Wall Street. It is wrong.

A Look at Historical Market Losses – Downside Risk You can get a fair perspective on risk by looking at actual stock market losses compared to how much money was allocated to stocks. The table below is based on actual market losses (price) encountered in the brutal 1973-74 bear market. A bear market is normally defined as a market decline of 20% or more. Drops of 10% to 15% are called corrections. Note in the table that a 100% stock portfolio lost nearly 50% of its value in two years (46% actual). If you had 50% stocks and 50% bonds, your loss would have been limited to 20%.

Equity Exposure……. Max loss
20%…………………………………5%
30%……………………………….10%
40%……………………………….15%
50%……………………………….20%
60%……………………………….25%
70%……………………………….30%
80%……………………………… 35%
90%……………………………… 40%
100%……………………… …… 50%
Data provided by Author Larry Swedroe on Morningstar’s ‘Bogleheads Unite’ Forum

On average, a bear market has occurred about every 5-6 years. Note that the two major bear markets since 1973-74 (2000-2002, 2008) have had drops very close to those of 73-74, but there is no guarantee that we can’t see one with greater losses. Also, be aware that some charts will show you worst one year losses, but most all of the worst bear markets incurred losses in two or more successive years, meaning the real total loss is worse than shown. When you have many years to go until you need the money and you have a reliable income, larger losses may be tolerated. When your time-line is shorter, 10-12 years from retirement for instance, you will want to reduce your allocation to stocks and go into defensive or asset preservation mode.

Here are two links to historical bear market data:
http://dividendpirate.com/2008/09/12/bull-and-bear-markets/
http://allfinancialmatters.com/2008/02/11/a-look-at-the-nine-bear-markets-since-1950/

Making Up A Loss
Another way to help you decide on an asset allocation and risk level is to look at how much you have to earn to make up for a loss. Here is a table that shows the required gain for a given loss. Notice the make-up rate is not linear. The higher the loss, the higher the required gain to get even.

Loss (%)… Reqired Gain
5%………….. … 5.2%
10%…………….. 11%
15%…………….. 18%
20%…………….. 25%
25%…………….. 33%
30%…………….. 43%
35%…………….. 54%
40%…………….. 67%
45%…………….. 82%
50%…………… 100%

As you can see, a 50% loss from an all stock portfolio requires a 100% gain (it needs to double), but a 20% loss, which would equate to a portfolio of 50% stocks and 50% bonds, only requires a 25% gain. As Terry Savage notes in her book, “The Savage Truth on Money,” “Getting even with the bear is tougher than getting ahead.” What Ms. Savage is saying is it is much easier to moderate a major loss than try to make up for one. To take this one step further, let’s look at what happens to two portfolios, one 100% stock (investor A) and one 50% stock (Investor B). Let’s assume each is 5 years from retirement and each has accumulated $600,000 in assets. If a severe bear market occurred, investor A’s portfolio would drop to $300,000 and Investor B’s would drop to $480,000. Investor A must now double his assets—a 100% return—to get back to where he was before the bear. At the historical rate of return of 9.9%, this will take him 7 years. Investor B only needs a 25% return to get even again. With an 8.2% return—the historical return of a 50/50 portfolio—he can do this in 3 years. Recovering losses may not take as long as these example because in many cases substantially higher returns were generated in market recoveries. But quicker recoveries can’t be relied on if your future goals depend on the money being there.

One thing to note in these examples is that when the AA is reduced from 100% stocks to 50% stocks, the returns don’t get reduced by half, i.e. 9.9% vs 8.2%. When assessing your risk, consider your ability, willingness and need to take the risk. A younger investor will have more ability and may have more willingness if he has a secure job and a regular income and is continuously adding to his investments. He also has more need. Young investors need to grow their portfolios with a larger allocation to stocks. Ultimately, your asset allocation should be based on your entire financial situation. For instance, an older investor who has a pension or other steady income plus his investments has some stability and therefore may have some ability to take additional risk. A retiree depending only on withdrawals from his portfolio may not. Most retired investors need to think in terms of asset preservation with larger allocations to bonds.

Author Larry Swedroe, in his book, “The Only Guide to a Winning Investment Strategy You’ll Ever Need” suggests you not develop an asset allocation in isolation. You need to thoroughly review your financial and personal circumstances. Consider things like your need for cash reserves, job stability, job correlation to the economy and the stock market, investment horizon, insurance, estate planning, and back-up resources.

John Bogle, former CEO of The Vanguard Group and author of “Common Sense on Mutual Funds” says it clearly: “Choose a balance of stocks and bonds according to your unique circumstances—your investment objectives, your time horizon, your level of comfort with risk, and your financial resources.”

Suggested Allocation Ranges
The stock exposure an investor can choose ranges from 0% to 100% of course, but there are some guidelines. Young, inexperienced investors believe that with time on their side they can go 100% in stocks. And some retired investors believe they don’t need and don’t want any stock at all. Neither of these extremes seem to be a very good choice. Legendary value investor Benjamin Graham recommended holding no more than 75% stock and no less than 25%. William Bernstein points out in his book The Four Pillars of Investing that a portfolio with 80-85% stocks and 15-20% in bonds and cash reduces downside risk to a significant degree while hardly reducing returns at all. Here are the numbers. Please note that the returns used are historical. Future returns may be different, but potential losses are related to asset allocation and not returns, so they would remain about the same. If you think about this for a second, you will realize that the lower the expected returns, the less incentive there should be to take the risk of very high stock allocations. There is less on the up side without a reduction on the down side.

Average Annual Return – world stock portfolio
(Equity = 50% U.S/50% International – Bond = Total bond.) 1970-2009

100% Stock Portfolio = 12.4%
80% Stock, 20% Bonds = 11.5%
60% Stock, 40% Bonds = 10.5%

Maximum one year loss Note: Largest one year loss since 1970 occurred in 2008
100% stock = 43.1%
80% Stock, 20% Bonds = -33.4%
60% Stock, 40% Bonds = -24.5%
Data from Paul Merriman, Fine tuning Your Asset allocation – 2010 Update.

Note that going from 100% stock to 80% stock results in a return reduction of 7% and a worst one year loss reduction of 22%. A good compromise? Of course. On the other end of the spectrum, having no stocks at all exposes older investors to no growth, which may mean faster drawdown of their portfolios. Also, having 15-20% stock and the rest in bonds and cash actually provides little or no additional risk and better returns. Here are the numbers for the reverse portfolios of 100% bonds and 80% bonds and 20% stock:

Average Annual Return 1960-2004
100% Bond Portfolio = 7.2%
80% Bonds, 20% Stock = 8.1%

Loss in 1969 (Worst Year Loss)
100% Bond Portfolio = -8.1%
80% Bonds, 20% Stock = -8.2%
Data from Vanguard

One last note on choosing an allocation: Kahneman and Tversky discovered in their behavioral research study that a loss of $1 is approximately twice as painful to investors as a gain of $1 is pleasant. Why? The gain is expected, anticipated, and exciting. But the loss is not only somewhat of a surprise, it is a setback and may be seen as failure of the plan. People do not like losing their hard-earned money.

E. F. Moody, CPA clarifies this in his online article “Risk and Other Stuff About Investing: Though rarely commented upon, recent studies show that investors are not necessarily risk adverse as much as they are loss adverse.”

Frank Armstrong, CFP, author of “The Informed Investor,” likes to say “The impact of asset allocation on investment policy swamps the other (investment) decisions.”

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