Mitigating Risk: Is it risky business?By Mike Kazakewich
“The only way to effectively mitigate risk…is through the intensive, personal process of financial planning.”
In recent years, investors have been inundated with products attempting to mitigate risk and perform during tail events in the market. Books writ-ten for a mass audience have touted asset allocation models optimized to reduce portfolio risk. Television commentators have highlighted methods to reduce risk, suggesting that their methods are appropriate for every viewer.
The problem with these methods, however, is the advice applied to the investor with a $100,000 IRA is the same as that applied to the individual with a $30 million dollar portfolio. Because these solutions are designed to be accessible to everyone, they ultimately fail to be useful to anyone.
We have found that the only way to effectively mitigate risk is not through a product, but through the intensive, personal process of financial planning. The difference is in being proactive as opposed to predictive.
Predictive models assume the market follows discernible patterns and that if you understand what they are, you can make an educated guess as to how it may react under different scenarios. Such guesstimates can be made only on the basis of computer-driven algorithms or human assumptions based on experience. And of course it is appealing to believe that one can tactically side-step risky times in the market.
The problem, though, is that when everyone possesses the same set of data points (historical market trends) and inputs them into their tactical models, that data loses its significance because the outcome is “gamed” by the desired result or outcome. In short, markets are governed by another huge variable: human behavior, which is very difficult to model or predict, so inevitably the model works—until it does not.
The proactive approach, in contrast, is client focused and planning based; customized to the client’s goals and objectives; and most importantly, to his or her risk tolerance. Through the process we determine how much risk a client needs to take, rather than how much risk he or she wants to take.
When engaging a new client, we employ a process called “risk budgeting.” This consists of segregating assets into three pools based on their risk profile: safety, market and aspirational. Each pool is distinguished by the level of risk or volatility inherent in the assets that reside there. The safety pool is comprised of assets that, if lost, would have a material impact on one’s lifestyle. Homes, cash, and life insurance policies are relegated to the safety pool. Assets in this pool may not keep pace with inflation, but their relative stability is paramount.
The market pool is comprised of portfolio assets. These are the work-horse assets, which over time, produce the capital growth and income to supply the safety pool with income to maintain lifestyles. The goal of assets in the market pool is to outperform inflation.
The aspirational pool, in contrast to the safety pool, houses assets that are more risk oriented. A concentrated position in an employer’s stock, an illiquid hedge fund or the assets for a family foundation may reside in this pool. When allocating assets to this pool, we look for enhanced return commensurate with the increased risk or volatility inherent in the asset.
Once we understand not only where the exposures lie in a client’s situation, but also his or her goals and objectives, we can begin to make recommendations that respond to the client’s needs.