The typical money manager uses a “risk based” approach to decide what portfolio allocation they will recommend for a client investor.

Risk Based Approach: The money manager gives the client a “risk questionnaire” to fill out. The goal of this questionnaire is to assess the client’s “risk tolerance.” By inputting the risk tolerance and age of the client into a standardized formula a recommended allocation is generated for the client.

The Many Shortcomings of Risk Based Method

1. The risk method does not take into account what the client’s goals/objectives for their assets. It does not take into account growth or cash flow needs of the portfolio. The most important question in determining portfolio allocation should be “What are we trying to accomplish?”, and this method completely disregards it.

2. These questionnaires assess an investor’s comfort and understanding of volatility. The term risk is misleading. A client investor may not have a great understanding or comfort of risk, they are not professional investors. It is really risky having a portfolio allocation that has a low probability of achieving your goals because your money manager was too lazy or inept to explain the difference between risk and volatility.

3. These methods almost always use a formula involving age to calculate the investor’s time horizon. Age is a factor in determining time horizon, but age alone does not determine time horizon.

4. In this method the client/investor is determining the asset allocation based on their understanding of and comfortability with market volatility. If an investor is going to pay a professional money manager, shouldn’t the money manager make an allocation recommendation for the client?

Goals Based Approach: Full disclosure, this is the method I use when working with my clients. After taking a full inventory of the investor’s assets, liabilities, current and future cash flows money manager and investor discuss the needs of the portfolio. What does the portfolio need to do? The manager and investor create a hierarchy of goals and objectives that may look like this:

Objective: Meet cash flow distributions of $40,000 annually while maintaining or growing account size. Goal: Grow portfolio as much as reasonably possible over the investment time horizon while meeting cash flow objectives.

Then a simulation or stress test is performed with different asset allocations to see what allocation gives the investor the highest probability of achieving their goals and objectives.

Shortcomings of Goals Based Method

1. Manager and investor need to successfully define goals and objectives, which can sometimes be difficult.

2. The simulations run to test different allocations make certain assumptions. Typically those assumptions are that stocks and bonds will perform much as they performed in the past. Unfortunately past results is NEVER a guarantee of future results.

3. The simulation does not factor in underperformance or outperformance of the portfolio over its given time horizon.

No method of choosing a portfolio’s allocation is perfect. I do think the Goals Based Method is superior to the Risk Based Method, because it is based on probabilities of achievement instead of investor’s comfort or understanding of market volatility.

The protégé to Milton Friedman and great economist Thomas Sowell is a personal hero of mine. One of his books Economic Facts and Fallacies is the inspiration for a series of posts I will be writing on this blog titled Myths & Fallacies. My posts will be economically related, but will focus specifically on investing, financial planning, and capital markets as always.

Too often folks equate stocks with risk. This is a fallacy. The idea that more stocks equals more risk or that less stocks equals less risk is a myth. It is true that stocks are much more volatile than bonds over short-term periods. Volatility or short-term unpredictability should not be used interchangeably with risk.

Risk is the potential of gaining or losing something of value. Stocks and bonds both have the potential to lose value. Stocks have a much higher probability of losing value from day-to-day or even year-to-year than bonds have, and too often that leads folks to say things like “bonds are safer than stocks.”

Is that really true though, are bonds safer than stocks? If your definition of safe is a higher probability of lower long-term returns with less short-term volatility, then yes, bonds are safer.

That is not my definition of safe, and hopefully it is not your definition either. I think the safest investment is the one with the highest probabilities of success. There are no certainties when investing, only probabilities.

Think about this, over 20-year rolling periods stocks have outperformed bonds 97% of the time, and have an average a cumulative return of 908% vs. a cumulative return of 247% for bonds. Over 10-year rolling periods stocks have outperformed bonds 82% of the time and have a cumulative average return of 209% vs. 80% for bonds.

If you had two different options for placing a bet, and one had significantly higher probabilities of winning with a better payout; wouldn’t you do that one? Of course you would.

Many investors mistakenly invest too heavily in bonds, and not enough in stocks. They do this, because they think they are doing the safe and conservative thing.

The reality is that feeling safe and investing too conservatively, is often the riskiest thing an investor can do.

More stocks DO NOT equal more risk in a portfolio. The “risk” of the portfolio should be defined by its likelihood of meeting the objectives of the investor. Given the time horizon and goals of the investor there are many instances where adding more stocks to the portfolio will increase the probabilities of success and therefore actually reduce the “risk.”

Don’t you see what’s happening? Potter isn’t selling. Potter’s buying! And why? Because we’re panicking and he’s not. That’s why. He’s picking up some bargains. Now, we can get through this thing all right. We’ve got to stick together, though. We’ve got to have faith in each other.
George Bailey – It’s a Wonderful Life

That quote is from one of my favorite movies, and it is very appropriate given the current market environment. In this scenario the hero George Bailey and the bad guy old Mr. Potter prove to be strong investors. They both see the big picture, they see the long-term perspective, neither character panics, and both maintain faith in the future despite a murky present.

As of yesterday the Vanguard Total World Stock (VT) was at -10.33% for the year. Starting this week the S&P 500 was at -7.93% and the MSCI EAFE was at -8.79% for the year. Since the first trading week of 2016 markets have been dropping, and they have been dropping fast.

My recommendation is to be like Mr. Potter and George Bailey. Do not let the emotion of seeing account values fall dictate your actions. If for some reason you have extra cash within your portfolio, put it to work. Price movement alone should never dictate your investment actions.

The current market downswing is one of two things. It is either a correction within a continuing bull market, or it is part of a new bear market cycle. Neither is provable while occurring, we will not know which is occurring with certainty until we are able to look back.

If it is a correction, the play is simple. As investors we should hold our positions confident that our asset allocation is appropriate for our goals, time horizon, and cash flow needs. We should sit back and put our feet up, while the weaker investors weed themselves out and inevitably whipsaw their returns.

If it is part of a bear market cycle, the play to make is more complicated. If this was a bear market that was preceded by over enthusiastic market sentiment with wobbling economics/fundamentals (like what we see in China), then we would have considered going defensive prior to now.

Hundreds of years of market data have proven that an investor can achieve very strong returns while taking the full brunt of bear markets, as long as they do not miss out on the Bull market cycles. When an investor takes a defensive position or takes money out of stocks, they are betting against hundreds of years of data that says “when in doubt, hold and wait.” Investors can predict bear market cycles and position portfolios accordingly. Accurately predicting bear markets can help an investor achieve superior long-term returns, but it is very very difficult. It is also the most dangerous move an investor can make, because the investor risks being wrong and missing out on bull market returns.

I think that we are in a correction and not a bear market, because I do not see material change in the world from three weeks ago. I do not believe the global economy is threatened by slower growth in China or low oil prices. As I see things, the likelihood of a recession in the US or Europe is low.

The USA and international developed economies are still poised to grow at the low but steady level of 2-3%. Exports to China account for less than 1% of US GDP, and exports to China account for less than 1.5% of Eurozone GDP. Volatility and/or a bear market in Chinese equities could lead to a period of heightened volatility globally, but will not lead to a global bear. The equity prices in China were drastically overbought given the fundamentals of the underline companies, and they crashed much like tech stocks in 2000, or all stocks in 1929. There should not be any contagion for global developed stocks or their underline companies.

Low oil prices or low energy costs hit energy companies hard, because they are very price sensitive. Low energy/oil prices act almost as a tax cut for consumers though. Consumer spending is a much bigger portion of GDP among developed economies than energy is. Low oil prices are a wash economically, or perhaps even a net positive.

Of course the market is a master at humiliating investors and maybe I am its next victim. That is why asset allocation, the correct mix of stocks, bonds, and cash is so incredibly important.