Russell Robertson, CFP®
Risk is one of those words that means something different to everyone...and therefore has people coming up with various vague yet philosophically profound-sounding definitions like “the possibility of more things happening than will happen”, “the unknown”, or “am I the eponymous character in a live-action Schrodinger’s cat experiment?” (okay, we made that last one up).
For financial planners like us, risk is paradoxically both the antithesis of our business but also the main reason we’re needed in the first place. Heath Ledger’s Joker had a nice little quote about this very thing:
Batman: “Then why do you want to kill me?”
Joker: “I don’t...I don’t want to kill you...what would I do without you? No, no, no!...you….complete me.”
Technically, I think in that example risk is actually Batman to the financial planner’s Joker...but we’ll go with it anyway. So where does risk come into play in financial planning? Well, everywhere. But we’ll just look at two examples today: insurance and portfolio management.
The idea behind insurance, broadly, is that risk (and the costs associated if said risk comes to pass!) gets shared among a large number of people.
For a simple example of how this works: suppose there are 10 houses in a neighborhood, and statistically, say there’s a 10% chance that one of the houses will be struck by lightning in any given yeasr, necessitating repairs costing $1,000. Without insurance, each homeowner would just cross their fingers and hope it wasn’t them that year...or send the least favorite child out with a kite to role-play Benjamin Franklin any time a storm passed through. With insurance, each homeowner pays $100 a year, and whoever gets struck by lightning gets the $1,000 insurance pool to cover repairs. With insurance, the risk - and the cost - of getting struck by lightning is shared equally among everyone.
If you could find $1,000 lying around your house and wouldn’t mind not having it, then maybe you don’t need to pay the $100 yearly premium. But, if you’re like the 63% of Americans that can’t afford an unexpected $500-$1000 payment (see this article from Forbes for more details), it’s a good idea to budget for the $100 premium every year. From a financial planning standpoint, you want to have insurance to cover risks that would be catastrophic. Insurance premiums are likely not worth it if you can cover the potential costs without any trouble, but if the costs would seriously impact your financial situation, paying up for the insurance is probably a good idea.
Take life insurance policies:
If you are a younger couple with kids and only one parent working, life insurance on whomever is working is a good idea because loss of that income would be fairly catastrophic for the rest of the family (above and beyond the actual dying - we’re taking the financial viewpoint here). If you’re young and don’t have anyone dependent on your income besides yourself, chances are you don’t need it right now.
What if you’re retired or about to retire? It depends - life insurance could be used to make things easier for the surviving spouse (pay off the house, cover funeral home costs, etc.) or leave some money to children or grandchildren. But if you’ve paid off your house and have a portfolio that already meets your needs for covering expenses and leaving any bequests (insert shameless plug for having a financial plan here), then you probably don’t need one. Especially not one for multiple millions of dollars.
And this brings us to what we believe is a valid criticism of the insurance industry: overselling. Insurance agents almost always get paid on commission. Thought experiment: which one of these would have the higher commission:
$1,000,000 life insurance policy
$2,000,000 life insurance policy
Not a trick question, the answer is 2. So the incentive there is for an insurance agent to get you to buy as much as possible, because it fattens their paycheck. And the way this overselling seems to occur is mostly by selling through fear, which doesn't sit well with us. Here’s what we mean:
"Imagine what would happen to your kid if you died tomorrow. Wouldn’t you want her to be taken care of? You know what would do that? One hundred thous - no - one million dollars...of life insurance.”
Too many times we see insurance companies throw a worst-case disaster scenario out there and then ask you to pay up as a way to avoid said scenario. Have you seen those commercials where someone is standing in front of the statue of liberty telling a story about insurance - like, how they got hit immediately after driving their new car off the lot and insurance only covered 75% of the cost of the car?
Well there’s a good reason for that. One, everyone knows that the car itself isn’t worth what you paid for it as soon as you drive it off the lot. The only thing that depreciates faster than new cars is...newer cars. But seriously. It makes sense to insure your new car because losing it would generally fall under that “catastrophic” category for most people - severe disruption to daily living (getting to/from work? Taking the kids around?) coupled with expensive to replace. But do you need to insure it for 100% of the value? If you try and resell that car, you won’t get 100% of what you paid for it, so why insure it for more than it’s worth? That’s just throwing money away on premiums.
Say you’re going to have the car for 6 years (theoretically), and after those 6 years it will be worth 50% of what you paid for it. Well in that scenario, insuring 75% of the cost sounds more reasonable - if the car gets totaled in the first year or two while the actual value is more than the replacement value in the insurance contract, then sure, you’ll have to come up with a little cash to make up the difference. But that is no longer a catastrophic event, and at the same time you’re not overpaying on premiums with money that could be put to better use.
At Alidade Wealth, we made the express decision to not sell insurance to our clients. We are happy to consult with you and review your insurance coverages for appropriateness, but don’t believe that receiving commissions from products we recommend is in the best interest of our clients.
The other place people commonly encounter discussions of “risk” is with their investment portfolios. Here, risk is typically expressed as a measure of volatility, or how much variation there has been historically in performance (standard deviation, for the mathematically inclined out there). Higher volatility is said to be riskier. If you have a portfolio with a standard deviation of 9.5, that can be said to be riskier than a portfolio with a standard deviation of 6 and not as risky as a portfolio with a standard deviation of 12, but...really, what does that mean for you as an investor? Not much, we’d say.
Let's imagine two data sets that represent portfolio returns over 20 years. Without reproducing the full data sets, take our word that the average return and standard deviation (variability of returns) is as below:
Portfolio 1: Average return: 5%; Standard Deviation: 12%
Portfolio 2: Average return: 5%; Standard Deviation: 7%
Question: Which of these portfolios did better at the end of the 20 years?
Trick question! We don’t know exactly - those of you who read last month’s note should remember that the sequence of returns can lead to differences in portfolio values even with the same average returns. But essentially, these two portfolios both got you to roughly the same place after 20 years - good enough for jazz, as they say. Various portfolio theories and risk models would tell you that everybody and their sister should be in Portfolio 2 because it is “lower risk” for the same return, but really, after 20 years - it didn’t matter. Maybe Portfolio 2 helped you sleep better at night, and that’s a perfectly valid reason, but from a return perspective the two portfolios are (almost) identical.
As an investor, the risk you have to contend with is not the standard deviation of your portfolio. The risk to you is that actual realized returns of your investments will fall short of the assumed returns in your plan. If you saved up every month for retirement with the expectation that your savings would grow at 5%, either portfolio worked perfectly well for you. If you were saving with a return assumption of 6%, well...sorry. Hope you like your job, because you’ll be there another couple years.
Every financial plan assumes a rate of return on investments, and this assumption underlies everything - how much money you’ll need at retirement, how long your money will last, how much you need to save every month/year - everything.
Have you heard in the news recently about pension funds being underfunded? Central States is the big one in the spotlight currently, but the picture isn’t really great for any of them. Why, you ask? Well, a couple reasons, but a big one is that most pension funds are working with the assumption of 7.5%+ average returns on portfolios. That means they fund future payouts assuming that the money they put aside today will grow (on average) at 7.5%. Pension fund portfolios are categorically not 100% stocks. Too risky. They are a mix of stocks, bonds, cash, and alternative investments. This type of diversified portfolio hasn’t seen long-term (10-yr) average returns above 7% since the 1998-2008 period. That means that any money pension plans have invested invested from late 1998-on (18 years now!) hasn’t seen the kind of returns they budgeted for. Not a good situation.
Our view here at Alidade Wealth s that from today’s market levels, average returns over the coming decade or so will be significantly lower than most people expect. We believe our hands-on approach to investment management has the potential to improve those long-term returns relative to a “set it and forget it” strategy, but whether you are using us for asset management or not, we would strongly recommend taking a look at some of the assumptions underlying your current financial plan and expectations for the future.
To think that your portfolio will just sit there and earn you 7% could get you caught with your pants down. And that is risky business indeed.
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