As an advisor, most of your clients have financial goals. That’s probably why they’re working with you in the first place—to help them identify and accomplish their goals. But when you create portfolios for clients, how do you consider the risk of the goal itself?
Most advisors build portfolios without explicitly considering the risks of the goal. Advisors tend to think about the efficiency of different asset classes (such as U.S. large-cap stocks, or U.S. small-cap stocks), but not things like how the risk structure of the goal covaries with different asset classes.
It’s common for institutional investors, especially for pension plans, to focus on the risks of the goal, which is also called the liability. This approach is commonly referred to as “liability-driven investing.” It directly incorporates the risks of the pension plan when deciding how to allocate the portfolio. For pension plans, the key risk is being able to make pension payments. A big driver of the cost of these payments is interest rates. If interest rates fall, the cost of future pension payments, or the liability, increases. One way to hedge this interest-rate risk is to invest in portfolio bonds with a similar duration.
Liability-driven investing is becoming increasingly popular among financial advisors, but it’s still relatively new. One type of goal that lends itself to unique portfolios is retirement. Most retirees want an income stream that increases by inflation throughout retirement. From this very simple perspective, it’s obvious that making sure the portfolio keeps pace with inflation is important. If inflation is high, the cost of the goal is going to increase. Therefore, you want a portfolio that’s going to perform especially well if inflation is high.
One problem with just extending the framework used to invest pension portfolios for individual investors is the nature of the retirement goal isn’t the same as a pension goal. With pensions, the plan sponsor has to make the payments, there’s no flexibility. With individual investors, people can usually cut back if they need to.
It’s important to understand all the aspects of the goal that affect the portfolio-decision process. For example, the more certainty your client wants with respect to funding a goal, the more conservatively the portfolio should probably be invested. This perspective really doesn’t have much to do a client’s risk preference (commonly assessed in a risk-tolerance questionnaire), but rather risk capacity, which is how much risk an investor should take given his or her situation.
Advisors may also want to consider the role of the portfolio when it comes to funding a goal. For example, when it comes to funding retirement, the portfolio is only one of many potential assets. A good chunk of the retirement income need for most Americans is covered through guaranteed income sources, such as Social Security retirement benefits or private pensions. This guaranteed income provides a bond-like benefit that’s very safe.
Know the risks of what your client wants to achieve and what risks might exist with the goal. We seek to build portfolios that have the same equity target (e.g., half stocks and half bonds) that look very different depending on the goal an investor is trying to fund and how far that investor is from this goal. I think it makes a lot sense for advisors to have a set of portfolios they use for accumulators and a set of portfolios they use for retirees, because retirement-focused portfolios should have different risk exposures (e.g., more U.S. large caps for equities and more cash and Treasury Inflation-Protected Securities as part of the fixed income).
Understand what level of certainty the client needs with respect to funding a goal. The more certainty required, the more conservative the portfolio should likely be.
Be aware of the role of the portfolio as part of the client’s overall total wealth. A client may be super conservative, but if he or she already has lots of wealth in pensions (e.g., Social Security retirement benefits), which many Americans do, it might make sense to be a bit more aggressive with the portfolio.