Balancing portfolio risk, return
Investors should establish minimum rate of return to act as a benchmark
Assessing appropriate risk for an investment portfolio is more art than science. While the tools for determining asset allocation between stocks and bonds are accessible and abundant, it may be that they are putting investors into inappropriate portfolios in the first place.
The key principal in modern portfolio theory is the concept of the efficient frontier — essentially, attempting to minimize risk while maximizing return — introduced by economist Harry Markowitzin his 1952 article Portfolio Selection, published in The Journal of Finance.
“The process of selecting a portfolio may be divided into two stages,” Markowitz wrote. “The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio.”
The efficient frontier involves a mathematical determination of how an investment portfolio should be structured to achieve the highest expected return based on the minimum level of risk for a particular investor. In theory, every investor has an optimal portfolio that resides on the efficient frontier opportunity set.
In practice, most investors end up with reasonably balanced portfolios when they invest with professionals. A balanced portfolio generally has about 60 per cent in stocks and 40 per cent in bonds. It is a frequent investment default that has become a rule of thumb midpoint for average investors.
Another frequently referenced rule of thumb is that an investor’s bond exposure should be equal to their age. This idea has come into question as interest rates have moved to artificial and historic lows at a time when life expectancy is on the rise. The result is that many are suggesting a bond allocation equal to age less an arbitrary number — 10 or 20, for example.
But, recent research suggests that the concept of decreasing stock exposure as you age may actually be flawed. A 2013 study titled Reducing Retirement Risk with a Rising Equity Glide Path by Wade Pfau and Michael Kitces in the Journal of Financial Planning suggests that equity exposure should actually increase in retirement.
The study points out that success for a retirement portfolio is highly dependent on the sequence of investment returns. If returns in the early years of retirement are good, a retiree may be so far ahead of their targets that any poor returns later in retirement are insignificant. On the other hand, if investment returns are weak in the early years of retirement, the conventional recommendation to reduce stock exposure over time may just ensure that the portfolio never recovers.
“Overall, the results show that rising equity glide paths from conservative starting points can achieve superior results, even with lower average lifetime equity exposure,” say the authors. “For instance, a portfolio that starts at 30 per cent in equities and finishes at 60 per cent performs better than a port- folio that (stays constant) at 60 per cent equities. A steady or rising glide path (also) provides superior results compared to starting at 60 per cent equities and declining to 30 per cent over time.”
As a financial planner, I believe a retirement plan should preface an investment plan and resulting asset allocation. When an investor can determine their required rate of return based on their assets, liabilities, income and expenses, they can build an investment portfolio with more personalized foresight.
As a baseline, an investor should then determine a minimum rate of return to act as their benchmark. This rate of return should be attainable based on their risk tolerance.
Research has also shown us that reducing the perceived risk of stock exposure over time can actually increase the actual risk of outliving your investments. So don’t be afraid to question whether your asset allocation should be different than what your investment adviser might otherwise assume.
Overall, the results show that rising equity glide paths from conservative starting points can achieve superior results, even with lower average lifetime equity exposure. — Wade Pfau and Michael Kitces.