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Applying Our Lessons

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

We have built a nice little portfolio, but it won’t be attractive to all investors. Some will want more return, and are willing to live with more risk to get it. Others will seek lower risk, lower return. How can we adapt what we have learned to meet the needs of diverse investors? Financial theory comes to the rescue with a neat and elegant solution: Simply vary the proportion of risky assets to the local risk-free asset.

In our case, we can use our globally diversified equity portfolio (Portfolio v5.0) as the optimal risky asset. Our short-term bond portfolio will stand in for the local risk-free asset, the Treasury bill. If we mix portfolios beginning with 100% short-term bonds and nothing in Portfolio 5.0, all the way up to zero bonds and 100% Portfolio 5.0, we will approximate an efficient frontier. Each portfolio will fall comfortably above the risk-reward line, and each will give us the best possible rate of return for the amount of risk endured. The line that connects each of these portfolios will look very much like the efficient frontier of classic Modern Portfolio Theory. The additional reward that we earn above the risk-reward line is the “free lunch” that diversification brings us.

In our case, we can use our globally diversified equity portfolio (Portfolio v5.0) as the optimal risky asset. Our short-term bond portfolio will stand in for the local risk-free asset, the Treasury bill. If we mix portfolios beginning with 100% short-term bonds and nothing in Portfolio 5.0, all the way up to zero bonds and 100% Portfolio 5.0, we will approximate an efficient frontier. Each portfolio will fall comfortably above the risk-reward line, and each will give us the best possible rate of return for the amount of risk endured. The line that connects each of these portfolios will look very much like the efficient frontier of classic Modern Portfolio Theory. The additional reward that we earn above the risk-reward line is the “free lunch” that diversification brings us.

Ahead of the Curve: By mixing various proportions of our optimal- portfolio (v5.0) and short-term bonds (STB), we can tailor strategies for different situations.

There will still be some investors who crave additional risk and reward. What should they do? There is a simple answer: Just take the optimal equity portfolio and leverage it. In other words, our risk-seeking investor can borrow money (on margin, as they say in the industry) and invest it in the optimal portfolio to extend the efficient frontier. Such investors better come equipped with a cast-iron stomach, though, because the bad days will be very, very bad. In practice, there aren’t many investors willing to put up with that much risk. I know I don’t have any clients begging for more volatility.

We still haven’t addressed the problem of where on the efficient frontier an investor should park herself. Here, modern financial theory comes up with an answer so impractical that we will ignore it. For those of you just dying to know, the textbook solution is to plot your indifference curves, find where they intersect the efficient frontier, and invest in that mix of risky and risk-free assets. I will freely admit to having no idea where my indifference curves are, and I don’t know anyone else that does either.

All is not lost, however. There are some sensible rules of thumb that we can apply. First, a portfolio should cover all of its known or reasonably predictable cash flows for the next five to seven years with a riskless asset. Once that’s covered, the remaining may be invested in a risky portfolio. If that mix is still too volatile for the investor, she may increase the riskless-asset weighting until the resulting mixture matches her risk tolerance.

Let’s look at asset allocation using a real-life example.

John and Mary, a young couple, have salted away a generous emergency fund. They wish to invest all additional savings to fund their daughters’ college education and their own retirement. They don’t anticipate any large expenditures during the next 10 years. The daughters are ages one and three. Retirement is a distant dream. This couple should consider investing only in the “risky” equity portfolio. However, if the prospect of equity volatility is unnerving to them, they might consider adding a 20% to 30% short-term bond position to dampen market gyrations. John and Mary opt for all equities.

Now, let’s fast-forward 10 years. John and Mary are disciplined savers. Their equity fund has grown nicely, but education is looming. They don’t want a temporary market decline to endanger their daughters’ education. So, John and Mary decide to convert a portion of the equity fund to short-term bonds, and to invest all new savings into a short-term bond portfolio dedicated to funding college. With the college expenses covered, the remaining growth funds are left to fund retirement.

After the second daughter’s college graduation, John and Mary resume their equities-only investment plan, focusing on a carefree retirement down the road. John’s job was “downsized,” but the emergency fund got them through the rough times until his career was back on track. Because they had the foresight to establish a generous emergency fund, they never had to invade the growth portfolio.

A few years before retirement, John and Mary calculate that after the company pension plan and Social Security, they will need about 6% of their nest egg (adjusted for inflation) each year for after-retirement living expenses. They decide that at retirement they would like to have seven years’ worth of income needs already covered by the short-term bond fund. This reserve will allow them to wait out any temporary market declines without invading their equity portfolio. Because seven years’ worth of income is about 40% of the nest egg, they set a 60% equity/40% short-term bond portfolio as a target at retirement. They begin to convert a share of their equity portfolio to bonds each year until they achieve that retirement mix.

After retirement, John and Mary draw down 6% of their capital each year as planned. When the market is bad, that comes out of the short-term bonds. When the market is good, they take their income needs by converting some equity holdings and then rebalance the portfolio back to the 60% equity target. On average they expect to make a percent or two more than they take out. The balance is reinvested in the plan to provide for an inflation hedge. By taking a percentage of capital each year rather than a fixed amount, they will receive a varying income stream. However, over time they expect their income and capital balance to grow in real terms. Another advantage to this approach is that it automatically adjusts income to remaining capital, so in the event of a prolonged market downturn it eliminates the unpleasant possibility of depleting the account to zero.

If John and Mary’s company pension plans had been so liberal that they didn’t need any income from the nest egg, they might reasonably not convert any of the equity fund to bonds. The asset mix is determined by their unique needs, not some arbitrary formula based on age.

By now, you may have noticed that this approach conflicts directly with the conventional wisdom that a retiree should invest for income. Retirees have long been advised to load up on long-term bonds, utilities, REITS, convertible bonds, preferred and other high-dividend stocks. However, this method leads to higher-risk, lower-return portfolios than necessary to meet the investor’s income goals. Investors should seek total return at the lowest risk position, and sell shares as required to meet their income needs.

Next time out we will begin to look at some alternative asset classes that might be considered for addition to a rational, global asset-allocation plan.