Client Portals

Securing Your Portfolio in a Complex World4 min read

Balancing Growth, Income and Uncertainty

Aug 26, 2020 - John Osbon ( 6 mins to read)

John Osbon

The traditional risk types of investors – conservative, moderate, or aggressive – were created by the investment industry for the investment industry. It was a way of merely categorizing investors so advisors could efficiently allocate money. These risk models were not created with the customer in mind and are often way off the mark in terms of actual risk. A better approach is to use liability-driven investing (LDI). LDI starts with the allocation of money to a protective reserve. The protective reserve will always be there regardless of market conditions. After the protective reserve requirements are defined and met in dollar terms, we can tune the rest of the portfolio for growth and long-term opportunities.

The rapidly changing investment world

Conventional wisdom has been drawn into question by COVID, and for the better. At some point, we will exit the COVID experience, but common risk-based investing categories will likely fall out of favor for some time. There is too much complexity in the world to rely on simplified models. When rapid changes happen to a complex system, safe assets can become risky and vice versa. A prime example of this phenomenon is the information technology sector.

COVID accelerated the need for technology to ensure business continuity. Many consider technology as the riskiest place to invest money, but it turns out that technology is now one of the safest places to invest. Technology allows businesses to continue functioning under a wide variety of environments. Cloud computing, semiconductors and all kinds of SaaS systems are essential to contemporary business practices. The best technology companies from big to small are at or above their highs for the year. We plan to address complex systems in future articles.

Investment questions and fact-finding

Liabilities-driven investing includes an investor’s current and future liabilities and resources. As far as risk metrics go, financial risks are essentially defined by how much you need to live at various levels and how much you expect to earn in the future. Looking at the full picture refocuses the portfolio construction away from an asset only approach to an approach that considers full context. 

Human capital, social security, illiquid assets, real estate, private businesses and private investments are essential parts of a family’s investment allocation. On the other side of the equation, the liability structure encompasses all funding needs for future life objectives, debt obligations and unrealized tax liabilities.

Defining a protective reserve

Creating a protective reserve is more art than science. Traditionally, industry participants have used Modern Portfolio Theory to construct portfolios to maximize expected returns based on a specific market risk level. This approach provides exciting insights, but it misses the protective reserve question altogether. Portfolios must minimize exposure to life’s real uncertainties, position assets for attractive returns and create robust financial structures. 

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. Our wealth management solutions must address a range of uncertain scenarios and black swan events. A protective reserve significantly reduces the need to gain certainty around risk. 

An investor in the early stages of their career tends to be underfunded in terms of their future liabilities, requiring substantial contributions from return-seeking assets to improve their funded status over time. Your needs for a protective reserve grow as you move from 25 and single, to 35 with a young family, to 50 with kids in college, to retirement, etc. There is no one size fits all approach here. Every client is unique. 

LDI and growth

Many future-leaning companies have returned 10x, 50x, 100x and even 300x since they went public. They are all well known, but not all appeared to be significant potential gainers every step along the way. With a proper family wealth structure, we can add small amounts into high growth situations like these 100x types with certainty that you won’t be spoiling your future retirement prospects in the event of a loss. Getting just one 100x return over a generation can create an enormous boost to wealth. Every individual should have a handful of potential high growth investments precisely because of their ability to go up many times over a long period. Patience and a long term view are essential. Low basis stocks like these make excellent gifts to charities and gifts to future generations with significantly reduced tax implications.

2020 and beyond

Complex systems and uncertainty characterize financial markets and our lives. Our liabilities driven investment approach captures a family’s full risk structure and forms the basis for all investment decisions. When there is an important personal or financial event, we add it to our liabilities model and discuss if any changes are desirable. Frequently there are. If you would like to know more about how this works, please give us a call or send an email. You can read more about this approach in The Math of Retirement by Max Osbon.

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