Monday, April 18, 2011

Worrying About the Wrong Risk

Sometimes stuff happens to make you rethink the basic premise behind whatever you are doing. At least it happens to me all of the time. The latest “stuff” is my recent Op-Ed in the Baltimore Sun regarding the investment portfolio for the Maryland State Retirement Plan, and my upcoming speaking engagement for the “X-Conference,” a gathering of some of the largest family offices in the U.S. and Europe. It occurs to me that both groups are investing portfolios that are so large that the industry’s status quo method of risk management, asset class diversification, should provide the participants sufficient protection against risk of loss. By that I mean the loss of their capital, as opposed to the risk of relatively underperforming a risk benchmark. I have written before about the status quo “playbook” for building quality portfolios, which is to craft a globally diversified portfolio consisting of multiple asset classes using no leverage. For institutional investors of state pensions, or managers of billion dollar family office portfolios, the diversification provides all of the risk management needed.

For Pinnacle clients whose portfolios typically range from $1 - $10 million, they have other risks to consider. Yes, we invest in globally diversified multiple asset class portfolios that are unleveraged, and yes, I believe this adequately defends against the absolute loss of their capital. When individuals are dealing with millions instead of billions the risk to their principal is more important to them than it is for billionaires, for the obvious reason that they have less to start with and so they can afford to lose less. But I think the real risk that Pinnacle clients need to focus on is not the risk of losing their capital, but the risk of persistently generating less than expected returns. As year-to-year gains and losses are strung together in a secular bear market, the high probability is that the portfolio will make money, not lose money, over time. The real problem is that the portfolio will earn much less than expected. The result of this past decade of stock market under performance is not that investors lost huge amounts of money in stocks. Trailing ten year returns including reinvested dividends are about flat. The real issue is that investors planned on 11% annual returns at the beginning of the decade and not 0% returns, and the resulting portfolio performance has been terrible versus expectations.

Institutional pension plans and family offices don’t pay much attention to year over year portfolio returns…they are instead focused on the returns of the money managers they employ to invest the asset classes in their portfolio. If their stock managers lost 20% in a market that lost 23% they are happy. Most folks with million dollar, rather than billion dollar portfolios, need to be concerned with absolute portfolio returns. When markets fail to deliver expected returns, some element of tactical asset allocation is required. As it happens, tactical asset allocation is our “bread and butter” around here. We are happy to wait for the rest of the industry to catch on.