by Chris Conroy Vice President, Advanced Marketing
According to Warren Buffet, “Risk comes from not knowing what you’re doing.” How much market risk can your clients bear? 10%? 25%? More? Warren Buffett’s insight on risk cautions investors to make choices they understand and only take risks they are willing to weather. Many may not even know how much risk they can or should take, but they should know and they need to know. Taking market risk with eyes wide shut is a recipe for disaster. Risk tolerance, in its simplest terms, is the willingness of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but probably lower, expected payoff. However, in today’s turbulent economic times, what’s the best way to help your clients appreciate their willingness to withstand market corrections? With the market free falls we’ve seen in 2008 and now in 2011, combined with the concerned client calls you’ve certainly received, it is critical that you help clients examine their risk tolerance.
This article summarizes a general risk tolerance principle to consider – the principle known as “Max Loss.” Undoubtedly, hundreds reading this have heard about the Max Loss concept from Creative Marketing’s president, Mike Tripses, during Creative Marketing annuity academies or other Creative events such as Learn To Earn. This new heuristic is simply that, a rule-of-thumb intended to help consumers better understand their market risk tolerance. It should not be used as an investment advice formula. Rather, it can provide an easy-to-understand way for you to explore with your clients their risk tolerance and which class of financial products might best suit their needs and objectives.
Risk Tolerance Models
Most everyone knows the “Rule of 100,” perhaps the simplest financial rule-of-thumb. Simply put, you subtract your age from 100, and the result suggests the maximum amount of your portfolio that should be exposed to market risk. At its core, it functions as a rudimentary life-cycle investment rule, and assumes that risk tolerance declines with age. Unfortunately, the Rule of 100 is too elementary and is not tailored to the individual saver. More complex life-cycle investment models1 do exist today, such as target-date mutual funds. Yet, critics have voiced skepticism at the high equity allocations2 found within such models. For retirees, the sequence-of-returns risk – the risk of facing a bear market forcing seniors to sell low to receive their income, leaving assets to get “made up” in the would-be ensuing bull market – can create significant retirement portfolio failures. Others may have used online “risk tolerance quizzes” which are inadequate because risk tolerance must be a discussion and a diagnosis, not just a “pass-fail” number.
On the other hand, there are some advisors trying to use complex risk management models in hopes of pegging the ideal allocation mix given a client’s risk profile. Consider concepts like Value-at-Risk, Monte Carlo simulations or square roots of variances. Phooey. Your clients need a simple way of considering the risk tolerance question. What is clear is that risk aversion should be the critical question your clients consider as they plan for a successful retirement.
The Max Loss Formula
The Max Loss formula seeks to help clients answer this simple question: What is the maximum percent of your portfolio that you should expose to market risk? This is determined by asking: What is the maximum percent of your portfolio that you can tolerate losing in one year? Next, ask: What is the maximum percent that you think the stock market can lose in one year? In order to limit a client’s potential loss, we need to understand the worst that can happen. Therefore, you ask two questions: What’s the most you can stand to lose? What’s the most you believe the market can lose? The Max Loss formula for calculating the maximum percent of a client’s portfolio that should be exposed to market risk is:
Max (R) = Maximum investment proportion in Risk Assets
Max Loss (A) = Maximum Loss tolerable of Total Assets in one year
Max Loss (R) = Maximum Loss possible of Risk Assets in one year
i = average interest rate on non-risk Assets
Note: “Risk assets” refer to those market-based assets which can lose money (e.g. equities, bond mutual funds. “Non-risk assets” are those that cannot lose principal (e.g. savings accounts, CDs, short-term T Bills, annuities, life insurance cash value)
Here is an example to help illustrate the Max Loss formula. Assume a 65-year-old client has $1 million in his portfolio to invest. The client does not want to lose more than 10% (Max Loss (A)) in any year. He believes the most his equities portfolio could drop is 50% (Max Loss (R)) (as it did several times in the past decade), and that he can earn 1.00% on five-year T-Bills (i). The Max Loss principle would suggest the client not invest more than 21.6% of his portfolio in market-risk products:
In short, this simple, understandable formula aims to help clients understand how much of their portfolio they are willing to put at risk of loss in equities, taking into account the clients’ opinion of market risk and their own risk tolerance – hence the term “Max Loss.” Additionally, the formula takes into account the changing guaranteed interest rate environments. Consider in the above example, had i been 5.0%, then the client could bear 6% greater equity exposure (i.e. 27% in equities). With greater guaranteed rates, a little more market risk can be taken. Also, for clients who can stomach severe market downturns, their Max Investment in Risk Assets may be a much higher percent. The point of the formula is to prompt a candid dialogue with clients about market risk tolerance and get them to understand the consequences of market corrections that may take many years to reverse. Below is a Max Investment in Risk Assets chart with an assumed guaranteed rate of 3.0%.
Risk Dialogue: Market volatility can be overwhelming
Market volatility can destroy a retirement plan, but many clients fail to properly appreciate this. We have witnessed 12 bear markets since World War II with prices declining 22% on average. What some analysts assumed were “outlier” scenarios or “black swans” have become reality for many investors. Most recall Black Monday, October 19, 1987, when the DJIA fell 22.6% in one day. Most recently, we recall when the DJIA had dropped 54% to 6,469 (March 6, 2009) from its peak of 14,164 in a span of just 17 months. Bear markets and high short-term volatility can often lead investors to fear further losses and retreat to more conservative risk tolerance profiles. They effectively “lock-in the losses.” For safety, retreating to more conservative investments with lower rates of return will require a number of years to recover from a downturn. With a shorter time horizon to recover losses, older clients cannot earn enough potential gains to benefit from a would-be recovery in market prices to restore their wealth. The chart below3 offers a hypothetical illustration of the years required to recover from various sizes of bear markets.
The increased volatility seen in today’s market is another important facet of the risk dialogue. Helping clients better understand their true maximum risk tolerance for their own equity portfolio (Max Loss (A)) is imperative for prudent product recommendation and satisfied clients.
Conclusion
Max Loss is a valuable tool for helping clients consider their market risk tolerance, but it does have its limitations. Purposely, it is simplistic. For example, it does not consider age, but could be utilized at various age stages of the client relationship, which may result in a different risk tolerance result. It also does not include features seen in complex models (such as risk/return frontier curves). The advantage of Max Loss is that it is a straightforward formula which every client can use as gut-check on surviving equity downswings. It will help you help a client determine how much is too much risk – and why. With the Max Loss formula, clients can better understand their true risk tolerance level and develop a sound financial plan with their eyes wide open.
1 Other popular life-cycle models include the Malkiel approach (1990), the Shiller plan (2005), and the “L Fund” plan offered to federal employees through the Thrift Savings Plan.
2 See “Optimal Asset Allocation in Retirement: A Downside Risk Perspective,” by Dr. W. Van Harlow, Ph.D, CFA, of the Putnam Retirement Institute, June 2011. See also “The life-cycle personal accounts proposal for Social Security: An evaluation,” by Robert J. Shiller, 2005 NBER Working Paper No. 11300, National Bureau of Economic Research, Cambridge, MA.
3 Illustration and assumptions from Putnam Investments White Paper, “Absolute return strategies offer modern diversification,” January 2011.
FOR AGENT USE ONLY. NOT FOR USE WITH THE GENERAL PUBLIC. 11945 - 2011/9/20
This material has been prepared for informational and educational purposes only. Agents may not give tax, legal, accounting or investment advice. Individuals should consult with a professional specializing in these areas regarding the applicability of this information to his/her situation.