Market risk isn't the real risk

Agency Sales,  Nov 2002  

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In the tumultuous final months of 2001, some investors lost their appetite for stocks. From September to November, investors withdrew a net $14 billion from wildly fluctuating stock funds and piled it into lower-risk assets, according to the Investment Company Institute, an industry association.

Taking steps to reduce risk might seem sensible, if not for this unhappy paradox: A less-risky portfolio could jeopardize your long-term financial health.

"People think of risk as their ability to withstand short-term volatility, but the real risk is not being able to meet the financial goals you're saving for," said Jack Brod, principal of Vanguard Asset Management and Trust Services.

Shortfall Risk

The likelihood that you won't meet your goals is known as "shortfall risk." It's based on a number of factors, which don't include the daily ups and downs of the stock market. Shortfall risk depends on your saving and spending patterns, future rates of inflation, your life expectancy, your estate plans, your asset allocation, long-term returns in the stock and bond markets, and your investment costs.

Most investors need a significant stake in stocks to help them meet their long-term goals. In the past, stocks have been subject to the biggest short-term losses, but they have also given investors the best chance of meeting their future spending needs. There are no guarantees, of course, but Vanguard expects this pattern to persist over the long haul.

Safer Assets, Higher Risk

Vanguard analysts examined the shortfall risk for hypothetical investors with a $1 million portfolio using three distinct asset allocations: (1) 100% bonds; (2) 50% stocks/50% bonds; and (3) 100% stocks. The analysis assumed an investment time horizon of 40 years, and spending of $40,000 per year, with annual adjustments for inflation. The simulations used actual investment returns (see the footnote that accompanies the table on page 30 for more details) and inflation rates from 1960 to the present, and then placed them in every conceivable pattern to "stress-- test" investment plans for worst-case scenarios.

The chart, on the right, shows the change in value of an all-bond portfolio using three different patterns of return - the worst case, the best case, and the average case, which is simply an average of all the possible paths from 1960 through 2000.

In the worst case, the portfolio experiences the pattern of returns provided by the bond market from 1965 onward - a period marked by bouts of high inflation and poor bond returns. The portfolio's assets are depleted in only 19 years, leaving the investor with a 40-year horizon in a tight spot. In the best case, returns mirror those generated by bonds starting in 1981, when bond yields were extremely high. At the end of a simulated 40 years, this portfolio would still be worth about $260,000.

Although the all-bond portfolio faced the lowest risk of short-term loss, on average, it carried the highest level of shortfall risk: The investor met his goals only 12% of the time. By contrast, a portfolio split evenly between stocks and bonds sustained greater short-term losses, but the investor had enough money to finance his goals 56% of the time. An all-stock portfolio carried the least shortfall risk, meeting the investor's needs 68% of the time. The trouble is, few investors have the emotional fortitude to withstand the gyrations of an all-stock portfolio. Also, despite our expectations, stocks may not offer the best returns in the future. The bottom line: Balance and diversification must be the cornerstones of any longterm plan.

The table above summarizes the values of the three portfolios in the worst, best, and average cases. It also displays each portfolio's ending values after 40 years, along with the rate of success in helping the investor meet his goal.

Control What You Can

Rather than fiddle with your long-term asset allocation in response to market volatility, you should consider the other factors that determine your shortfall risk. "You can't control market risk, but you can control your spending and saving," says Brod.

Again, consider the $1 million portfolio split between stocks and bonds. The investor could significantly improve the odds of meeting her goals by reducing her spending. If she cut spending to $35,000 per year (a figure that would go up each year to account for inflation), she'd meet her goals 85% of the time, up from 56% at a $40,000 spending rate. And if she cut spending to just $30,000, the chances of success reach 100%.

Low costs also help. We assumed that the $1 million investor paid an annual fee of 0.40% of assets. But if that fee were 1.40%, a level more typical of the mutual fund industry, a $1 million portfolio split between stocks and bonds would be depleted, on average, two years before the lower-cost portfolio.

Keep Your Goal In Sight

In Peter Bernstein's book on risk, Against the Gods, investment manager Robert Jeffrey explains that "volatility per se ... is simply a benign statistical probability factor that tells us nothing about risk.... The real risk in holding a portfolio is that it might not provide its owner . . . with the cash he requires to make essential outlays."