Investors have a tendency to obsess about their investment portfolios. On the surface, this is a perfectly reasonable focus given results in the portfolio are a crucial determinant of success for whatever purpose the portfolio is there to serve. But performance of one’s investment portfolio is not the only determinant of success, and it is almost certain that investors would achieve better overall outcomes if they recognized the risks outside of their portfolios that really matter and invested accordingly. Such a shift in mindset, while theoretically almost unarguable, does run into a couple of practical hurdles. The first is that the investment portfolio is the piece of the problem that is easiest to measure, and investment professionals are generally judged on measured outcomes. While a particular portfolio might be the right one for the specific assets and liabilities of a given investor, if that portfolio underperforms those of the investor’s peers, it is not clear whether an investment committee will care much about the theoretical superiority. The second issue is that once we move beyond the investment portfolio, estimates of risk and correlation are necessarily judgment calls and investors or risk managers cannot simply rely on a historical returns-based covariance matrix to estimate overall risk. That said, just because solving a particular problem is hard doesn’t mean the right thing to do is come up with an easier problem to solve that is less relevant. I’m going to make the argument as to why traditional ways of thinking about portfolios are flawed and can lead investors to make bad decisions.
The risks that matter
No investment portfolio exists in a vacuum. Every portfolio exists within a larger framework that includes both the purpose the portfolio serves – the liability – as well as any additional assets that will come into the portfolio over time. Risk is not merely a function of the volatility of the investment portfolio but also of the relationships between the investment portfolio, the liability, and the non-portfolio assets. Defined benefit pension fund managers are used to thinking about at least part of this conception of risk because accounting standards force them to recognize the way the pension liability varies with interest rates. In worrying about the funding ratio of the pension rather than simply the volatility of the portfolio, they are moving in the right direction. But most pension fund managers tend to stop there, failing to fully take into account the assets outside of the portfolio that are relevant to the overall problem – the potential of the fund sponsor to make additional contributions to the pension portfolio when needed. Because the sponsor’s ability to make these contributions varies depending on economic circumstances, all deteriorations in the funding ratio of the pension fund are not equal. A deterioration that occurs when the cash flow position of the sponsor is worse than average is significantly worse than one that occurs when sponsor cash flow is strong. Defining how much worse is a bit tricky, as it involves estimating the covariance between the sponsor’s cash flow and the investment portfolio as well as
coming up with some estimate of the amount of disutility that stems from having to top up the pension fund at a time of stress. But the fact that it is tricky to estimate the parameters of the true problem doesn’t mean that ignoring it is the right answer. And the difference between looking at the true problem and an oversimplified version can be a big deal, which I hope to demonstrate with a few examples. I’m going to be using mean variance optimization (MVO) for my examples, because it’s a widely used tool and most professional investors are familiar with it. But the basic concepts in no way depend on MVO, or indeed quantitative portfolio construction methods in general, to be relevant.
Non-portfolio assets matter for retirement savings
One place where incorporating the existence of assets outside of the portfolio has important implications is in what I will call the retirement problem. For our purposes here, I am going to assume that workers need to accumulate 10 times their final salary at retirement, that they save 10% of their income every year that they are working, and that as a base case, their salary will grow at 1% real per year throughout their working life. Their investment portfolios consist of stocks and bonds. I am going to assume that in a bad economic event there is a negative shock to both the returns to stocks and the income of the workers. It is this last piece that requires looking beyond the retirement portfolio itself in estimating true risk, and my goal is to show the implication of ignoring this covariance in building a retirement portfolio and why it is suboptimal. Exhibit 1 shows three different glide paths for three people saving for retirement – a teacher, a manufacturing employee, and a financial services employee.1 The differences between them are driven solely by the level of covariance2 assumed between employment income and the returns to stocks and bonds.
All of these investors have the same level of risk aversion, which explains why at retirement (here assumed to be 65 years old) they have the same portfolio allocation to stocks.3 But depending on the assumption we make on the correlation between stock market returns and each saver’s labor income and the volatility of that labor income, the ideal portfolio moves around a good deal. If we assume a strong covariance between labor income and stock returns, such as might be the case for a worker in the financial services industry, we get the interesting result that workers in their 40s or older should have less in stocks than they should at retirement. While this runs counter to the standard advice and most traditional retirement glide paths, it does make plenty of sense when you think about how a depression impacts someone who is relatively close to retirement versus someone who has already retired.
Read more here.
