Client Portals

A Plan That Works For The Future4 min read

Liability Driven Investing At Work

Jun 3, 2020 - Max Osbon ( 6 mins to read)

Max Osbon

Traditional solutions in investment management often start with client questionnaires that try to identify risk preference. The result may include something along the lines of, “I’m a risk taker” or “I’m a risk avoider”. That process, as common as it is, has little relevance to the true needs of a family investment strategy. When an expense is essential, you avoid risk in order to know that you will have that money when you absolutely need it. When capital is discretionary, it makes sense to welcome risks to grow capital for use in the future. We call this liability driven investing. Here’s how it works:

Inviting nuance through data collection

Liability driven investing (LDI) is more holistic than traditional portfolio construction techniques popularized by Modern Portfolio theory. By taking into account an investor’s current and future liabilities, we are able to create portfolios that are built to withstand best and worst case scenarios. This is particularly useful when it comes to retirement needs where we seek greater certainty around a given outcome (we wrote about this in January via the Math of Retirement). 

The goal of LDI investing is not necessarily to maximize the return of the asset portfolio, because seeking only to maximize returns often introduces excessive and unnecessary risk-taking. The goal of LDI investing is to maximize asset performance relative to a client’s future known liabilities. This provides a systematic approach to ensuring that all essential family items are sufficiently hedged while excess capital is freed up for long term growth.

Managing uncertainty and managing risk – key differences

Risk management is the foundation of any financial solution. Investors often confuse risk and uncertainty as being one and the same, but in reality, they are different concepts entirely. Traditional solutions often assume that risks associated with complex financial markets can be well‐described with simple applications of statistical methods like Monte Carlo simulations. These approaches are suitable to problems when we “know the game,” such as when rolling the dice or flipping a coin. The problem is that we do not live in a world of “risk,” in which we know the game. We live in a complex world of “uncertainty,” in which much of the game is unknown. 

This means that the range of possible outcomes is often far wider than most of us care to admit. One advantage to managing uncertainty is the increased likelihood to survive and thrive through a wide range of negative outcomes and still end up reaching your goals. 

As a side note, an over-reliance on statistical risk metrics has repeatedly led to major financial blowups because this approach fails to capture tail risk (tail risk = rare but severe circumstances). Statistical risk even gives some managers an excuse to pile on leverage while assuming that “statistically speaking, nothing bad is going to happen”. The blow up of Long Term Capital Management is a famous example. 

Calculating your protective reserve

The most basic needs of any investor center around housing, food and healthcare. Your lifetime stream of essential cashflows can be matched with assets that have very low probability of losing capital, such as TBills, TIPS, CDs, etc. Data sets that often get overlooked are guaranteed future income streams from pensions, social security, etc. All of these help to ensure that we move as much uncertainty off the table as possible. 

Managing risk then applies mostly to assets that are paired with future ‘important’ or ‘discretionary’ expenses, like education and philanthropy. After all reasonable essential, important and discretionary expenses are accounted for, the remaining assets can be invested for maximum benefit of future generations and beneficiaires.

A reserve of high confidence liquid assets has the added benefit of protecting against periods of acute distress. It may be used to cover several years of spending in the event of a reduction in income or a period of great economic uncertainty. Excess reverses can also be used to invest during opportunistic buying opportunities.

Putting this to work

Diversification, liquidity management, insurance, and protective reserves are tools to help you increase the certainty of your desired financial outcome. This is crucial to answering the question, “what is the right allocation for me?” Sourcing returns through equities, fixed income and alternative investments becomes a less stressful endeavor once it is clear that a family is well organized and financially robust. As 2020 has reminded us, strange events can and do happen. We can help you sort out your data and prioritize your protection methods so that you can continue to invest with confidence for years to come.

WEEKLY INSIGHTS
delivered to your inbox

DISCLAIMER

This communication may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.”

“Historical performance is not indicative of future results. The investment return will fluctuate with market conditions.

Past performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.

Investment strategies, philosophies, allocations and holdings are subject to change without prior notice.

This communication is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice.

While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.

Adviser does not endorse the statements, services or performance of any third-party vendor.

Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.

Any IPO alerts are purely informational and should not be construed as recommendations to invest.

Adviser is not licensed to provide and does not provide legal, tax or accounting advice to clients. Advice of qualified counsel or accountant should be sought to address any specific situation requiring assistance from such licensed individuals.

Any case studies or hypothetical client profiles are for demonstration purposes only. They illustrate the breadth and depth of the many clients we represent at various life stages. Any similarities to actual Adviser’s clients past or present are strictly coincidental. Individual advice and results will vary based on each client’s circumstances, objectives and prevailing economic conditions.