Horizon matching: the theme of two recent seminars
A key feature of the No Monkey Business investment approach, horizon matching, has been critical to protecting clients against adverse consequences of a bear market. Failure to match investment risks to time horizons for the money creates a linkage between investment portfolios and household cash flows that can and should be avoided.
A risk management approach focused on outcomes The consequence of that linkage for investors when markets fall is likely to be (at best) anxiety about actual planned cash flows (rather than just ‘paper’ valuations) and at (at worst) a forced lowering of planned or actual cash flows. In either case, the risk management approach is clearly failing.
To the extent our clients hold equity bets as a managed risk against longer time horizons, we cannot protect them from paper loss but we can persuade them, through our use of modelling, that this does not materially alter the projected outcomes of the plan we designed with them.
The impact of differentiating the consequences in this way was very well illustrated by a couple who have been clients for several years. They retired young and are dependent on their investment portfolio to support their planned retirement spending. They were asked by a friend, who knew this to be the case, whether they were worried. They have allowed us to quote from the email they sent us, as follows:
“Being away and out of touch other than catching ever more lurid headlines could have been very worrying. However it wasn’t until a chance remark gave us pause for thought that we realised just how relaxed we felt in the face of the present upheaval. No-one can be enjoying what’s happening in the markets and it would be wrong to be complacent but knowing that the portfolio has been tested to include such scenarios, and is structured to deliver our drawdown requirement for several years regardless, has given us a level of comfort which we realised we had almost been taking for granted. I don’t think we would have felt as in control a few years ago so thanks for that.”
With investment bets matched to their drawdown horizons, they know that for the early years of the plan the cash flows are fully matched by cash and index linked gilts. Even for the middle years, risk is managed by combining equity bets with index linked gilts. Only the later years, some 17 years off, are funded entirely by equity bets.
The resources required to fund those equity-backed time slices are absolutely realistic about the full extent of the uncertainty about real total returns from equities. There is no discounting of favourable payoffs, in the way occupational pension funds were funded in the past on a 50:50 outcome, or the way premiums were set for endowment mortgages, also with about a 50% chance of achieving their objective.
What is realistic? Historical evidence of real total returns from equities, based on as many markets as possible and as much history as possible, provides the data we rely on for our stress tests of the particular combination of resources, risk and outcomes that define each client’s goal-based portfolio.
Drawdown seminars The idea that investment portfolios are there to support dynamic and potentially very long-lived journeys was a key theme of two seminars we ran a few weeks ago for partners of London law firms.
The evidence of our difference in approach which they seized on (as Joe had when he first encountered our approach) is the division of the plan into a series of time slices, each separately funded by existing resources and each dynamically managed to its own asset allocation. It means that when we say the risk management process is fully customized it is not just a sales pitch: we can demonstrate it.
We show below an example we used in each seminar, for a drawdown plan with a 30-year horizon divided into 15 two-year time slices, with a profile of declining target outcomes for sustainable real draw. For simplicity, we have conflated two separate exhibits: i) resources in present values and ii) the probable outcomes as future values. The ‘candlestick’ bars for outcomes show the best case and worst case (derived from stochastic modelling of asset allocations managed dynamically to the shortening time horizons). As the early slices are consumed, the allocations to the right (red for risky) will move into risk free assets (blue) as a function of both time horizons and market conditions at the time.
The industry’s ‘factory model’ Behind the flannel about customised solutions, the industry widely relies on a small set of standardized asset allocations, usually differentiated by the degree of substitution of equities by conventional bond holdings. This approach, drviven by the economics of firms’ business models, involves shoehorning the client into one of these standard solutions rather than genuinely customising the solution.
Another feature seminar attendees were struck by was that the main form of risk control for the industry, adding bond exposure, does not even get the job done as it leaves investors exposed to a high degree of uncertainty about outcomes once these are measured in real terms, after inflation.
We suspect that concern about long-run inflation will take on more importance as people think about the way British governments have historically relied on inflation to reduce the real burden of national debt. It will be very tempting to take this easy way out of the present crisis, particularly because the cost in higher inflation may not show up until many years later.
It is striking that the market’s best measure of how concerned investors are about inflation, the real yield on index linked gilts, has shot up over the last few weeks as people have taken on board the heightened risk of recession and lost their fear of commodity-driven inflation. This is short-sighted.