One method is used throughout the financial services industry to measure and control investment risk. This is called “Efficient Set Theory” (EST), which is the risk control part of “Modern Portfolio Theory.” While we have always found it shocking how few investment advisors understand the mathematics in this theory, nearly everyone in the business uses EST to try to measure and control the risk in their accounts.
EST literally created the concept of diversification, the commonsense idea you should not “keep all your eggs in one basket.” During normal times EST gives a relatively accurate, detailed description of the volatility in any portfolio. In other words, it shows how much the account balance is likely to go up or down over different time periods. The problem with EST is that it does not work during extraordinary times. In particular, it doesn’t work when investors panic. When panic sets in, many people sell all their stocks and stock funds, and when the panic is widespread they may also sell many of their supposedly safe bond funds. Diversification, which works quite well most of the time, becomes worthless if people sell everything indiscriminately. As a result, the risk control method used by every major Wall Street firm and the vast majority of professional advisers ceases to work whenever serious risk occurs. In other words, it fails when you need it the most.
Let’s look at a real life example that illustrates this problem. In 2008 stocks in the United States lost 37%, international stocks lost 44%, real estate funds lost 40%, and commodities lost 37%. In other words, all assets at risk went down together. Even worse, supposedly safe “multisector” bond funds (which typically own all types of U.S. bonds) lost 15%. As a result, millions of investors who owned widely diversified portfolios experienced large losses.
So the method currently being used to measure and control risk clearly loses its value when large risk hits your portfolio. Given this fact, you might ask what the investment industry is doing about it. The answer is – absolutely nothing. When clients lose far more than they ever expected could happen, their advisor usually tells them the losses couldn’t be avoided. Clients are told they should just be patient and they’ll come out fine “in the long run.” The problem with this advice is that, due to huge losses in 2001-2002 and then in 2008-2009, most investors have made little or nothing from their stock investments for the last 14 years. And the future for the next few years does not look promising. So for people who retired around 2000, there is a real chance they may go through the first two decades of their retirement with no investment gains. Clearly the status quo is not working.
This should be a matter of utmost importance to any professional who manages retirement money, but the financial industry as a whole isn’t even trying to come up with a way to measure and control risk that actually protects their clients’ principal. From its inception, Secure Retirement found this situation completely unacceptable, and over the years we have found a far superior way to control risk in retirement accounts. Generally speaking, we use a method called “strategic asset allocation,” which uses an in-depth study of macroeconomics and markets to determine into which asset classes we should be invested at any point in time.
As stated above, the primary flaw of EST, the risk control method used throughout the investment management industry, is that it underestimates the risk that occurs during extraordinary times. EST is based on the assumption that investment returns fall in a standard normal distribution. Unfortunately, over time we have discovered this is inaccurate. Instead, investment returns have “fat tails,” meaning risk levels that should only occur once in a century actually strike markets more often.
For many years at Secure Retirement we have taken a comprehensive inventory of all macroeconomic risks, usually in January of each year. In this process we look at every conceivable risk that could hit markets, including stocks, bonds, commodities, natural resources and real estate, both in the U.S. and abroad. It should be noted that in “normal” times we find 2-4 risks that could threaten the market. However, in normal times we end up giving each of these risks a 1-3% probability of occurring in the following year. While the process is still worthwhile, as at Secure Retirement we always want to be aware of any risk that could hurt our clients financially, with only a 1-3% chance of occurring we do not take defensive action as a result.
However, in certain years we find extraordinary risks that have a much higher probability of actually striking investors. At this time our analysis leads us to conclude there is at least a 50% chance we will have catastrophic losses in the world economy and markets before the current market cycle is completed. Europe is likely to have a continuation of their financial crisis, while Japan’s debts make an eventual crash a near certainty. Then we have an historic debt explosion and real estate bubble in China. These are indeed extraordinary risks, and if any of these three economies were to fall too far, stocks around the world would plunge in value. Then in the U.S. we know there will be another recession at some point. We would expect it to be relatively mild, unless Europe, Japan and/or China collapse at the same time. There is a concern, however, that all of the normal measures taken to pull our economy out of recessions have already been fully implemented, which could make our next recession difficult to escape. But even in a mild recession, on average stocks lose approximately one-third of their value. Since they begin in a bubble, we have an unusually high probability of seeing most investors once again suffer devastating losses on their stock investments in the relatively near future. When we see such unusually large risks, at Secure Retirement we make sure our clients are fully protected. Unlike typical investment advisors who might reduce their risk a few percent if they see too much risk on the horizon, in extreme cases we design our portfolios to be so safe they not only should not lose but will most likely make extra profits if any of these major economic and market risks come to fruition.
Unfortunately, most investors are never able to buy good investments at truly bargain prices, i.e. to buy low. This is due to the fact most have lost so much money on the way down they cannot afford financially and/or emotionally to buy.