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 the future for the next 12 years does not look promising for stock markets, with no gains over that entire time period expected and a drop of 65% before stocks hit “fair value.” For a retired person, this is far too long to be patient – and far too large a drop in their account value. 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 far more often, and with more destruction.
Our risk control system is based on the principal that the level of protection our portfolios provide should become stronger and more certain when we see extraordinary risk directly confronting the markets.
When we see 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 will not only maintain the balance when risk hits but consistently, and progressively, rise when stocks fall.
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. That is the result of not having a risk control system in place before a crash, or not acting diligently and decisively when protection is needed.
Whenever looking at potential profits and risk control together, risk control always takes precedence. Occasionally, like today, they go together hand-in-hand. It’s unlikely we will ever again see a confluence of such potentially high returns from the asset classes considered the safest in the world.
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