How to Use Risk Buckets to Build a Smarter Wealth Strategy
Excerpt adapted from the Book:
The Aspirational Investor by Ashvin B. Chhabra
Just as the goals of each risk bucket are different, so, too, are the investments that you will hold within them, as well as the way each portfolio is constructed.
For example, you can put together your safety portfolio by considering your various risk factors and allocating resources (buying insurance) to mitigate them. This can range from buying a permanent home by making a large down payment on a reasonable home along with a long-term say thirty-year mortgage, to buying enough term life insurance to protect your family in case of an unfortunate event. The allocation of capital to mitigate each kind of risk in the safety bucket can be quite uneven, given that you are in essence buying various kinds of insurance and paying the corresponding premium demanded.
In the market bucket the goal is achieving market return, with minimal volatility, through diversification. You are avoiding the evils of concentration & leverage.
A great deal has been written about the best way to construct a market portfolio - but the key is diversification without compromising quality. We emphasize that indexing is a powerful low-cost way of achieving diversification that has over the long-term led to excellent results.
Capital allocated to the aspirational bucket is often focused on one principal venture - one that you are passionate about and have some expertise. As we have seen, the evils of concentration and leverage in the market bucket are your friends in the Aspirational bucket - with two important caveats. You should have some expertise or alpha in your investments here and the leverage must be non-recourse.
Once you are satisfied that your risk allocation expresses properly how much risk you can (and should) comfortably take, it’s time for a stress test to make sure that your assets are prudently allocated across the safety, market, and aspirational buckets.
Stress testing is crucial
Ensuring that your risk allocation and supporting portfolio strategy are as shockproof as you can reasonably make it. A standard Monte Carlo scenario analysis tool such as those employed by many financial advisors will provide you with the probability of achieving your goals. You want to be on track to reaching your essential goals with at least 80 percent probability, perhaps closer to 95 percent or 100 percent if you can. However, the incremental cost of certainty quickly becomes prohibitive.
Further, there are many more risks than those measured by the standard deviation of a normal distribution, as we have seen. It is thus important to test your portfolio against those seemingly “rare” market disruptions that seem to occur with alarming frequency.
Here are a few worthwhile stress tests:
Market Meltdown Test
This is the simplest, of course. Imagine you are in a situation where the market has fallen by 50 percent and your aspirational assets are worth zero. Your safety portfolio may also have taken a hit, with your home value down 20 percent. What impact does this situation have on your essential goals and meeting your family’s basic needs? If the results are catastrophic or unimaginable, you definitely need to rethink your current portfolio: such crashes can and have occurred throughout history, especially in the span of a human lifetime.
Loss of Employment Test
You lose your employment, your income ceases while your expenses remain constant, and the markets drop 50 percent. Would you still be able to protect your current standard of living? For how long? Could you keep key assets like your home or would you be forced to sell them at fire-sale prices?
Sustainability Test
For how long can your core financial assets (excluding personal assets like a home or car, as well as your aspirational investments) sustain your lifestyle?
Aspirational Goals Test
Looking exclusively at your aspirational goals, are you satisfied that there is a reasonable chance of achieving some of them? If not, would you be willing to take more risk, without endangering your essential goals? Would you be willing, instead, to adjust your aspirational goals?
Difficult to Quantify Risks Test
Define your hard-to- quantify risks. Could the cash flows change? Could your family situation change? What about a once-in-a-century earthquake or hurricane? Under what circumstances might there be no buyers when you wish to sell? What would happen if [ . . . ]?
Tests such as these are often hard to quantify, so there is a tendency to skip them or at least not to review them regularly. But in a really challenging situation, the soundness of this thinking will be critical to the survival of your wealth management strategy and offers the added insurance that your essential goals will be able to withstand such shocks.
And Keep Reviewing and Rebalancing
On an annual basis, it’s important to track how you are doing and to reassess your goals and risk allocation throughout market cycles and in the context of your current life stage. Simply put, you must evaluate how much security you need (safety portfolio) versus capital you are willing to risk losing completely (aspirational portfolio), and then put the rest in a diversified market portfolio.
A parting thought:
The truest test of a successful investing and wealth management strategy is whether it protects your essential goals from the whims of the market while still helping you achieve important goals and pursue your aspirations. It should also be easy to understand and give you a clear path to to get back on track if challenges arise.