Your financial goal in sight
Why private investor portfolios need to de-risk towards maturity
One the most important lessons for any private investor is this: If you have a long investment horizon, you can take more portfolio risk and therefore expect a higher investment return. The reason is simple: time diversification means that bad investment years are likely to be averaged out by good years.
If you were investing for your retirement in your 30ies, you would most likely take a large degree of investment risk to reap the benefits of higher expected returns towards retirement. However, as time goes by and retirement draws closer, should you keep the same investment risk?
In this note we explain why we believe a portfolio for a private investors should de-risk as the maturity of the investment goal draws closer and how we do it.
The risk of keeping the portfolio static
As noted above, the longer the investment horizon, the more risk we can take in the portfolio, as diversification means that bad investment years are likely to be averaged out by good years. As the maturity of our investment goal draws closer, the portfolio risk to a bad year or a single event increases, and the portfolio should be de-risked from riskier asset classes such as equities to safer ones like investment grade credit, inflation-linked government bonds or even outright cash. By doing so, one reduces the risk that a financial market crisis wipes out a large portfolio value just before the money is needed for the defined goal.
Let’s take a look at an example. Imagine it is 2005 and you want to save for a down payment on an apartment needed at the end of 2010. You believe 6 years is a long investment horizon, and you therefore decide to split your portfolio into 75% equities and 25% bonds to take advantage of the higher return potential of equity markets. In one case, you keep this allocation constant and in the other case you gradually reduce the equity allocation and thereby the risk of the portfolio. The two portfolios are shown in the chart below.
The de-risking of the portfolio over time has the advantage that one is less exposed to big market drawdowns. The important aspect is that the closer you are to your target date, the less options you have to make up for potential negative market returns. If there is more time left, there is a greater chance that financial markets will recover or you can adjust your expenditures and save more and you typically have more flexibility to adjust the target date of your goal. The chart below shows how the two portfolios would have performed during the period that included the financial crisis of 2008. The fact that the portfolio with a dynamic asset allocation and de-risking has a higher cumulative return is nice but not the most important aspect here. If we had selected a different historical period, the return might have been a different one. The important aspect is that the volatility of the portfolio declines over time and that we are better shielded from severe market downturns.
There are two key aspects to consider:
- How should I adjust my asset allocation over time?
- What is the expected return of the portfolio that dynamically adjusts?
Financial advice: Once is not enough
The investment advisory process of most banks and robo-advisors starts with an investor risk profiling that includes a simulation of future wealth, based on a static portfolio. This is often a one-time process, and the need for a review and a change of the asset allocation over time is often ignored. There are potential grave consequences to this approach. First, by not reducing the portfolio risk, the investment portfolio is endangered ahead of a financial life goals, such as retirement. Second, if we actually do reduce the investment risk towards the target date, we would have overestimated the expected return until the target date and by extension allocated too little capital towards the financial goal. This has the likely consequence that we will not have enough money for the goal we planned for.
Solution: A plan for your portfolio allocation over time
The solution is in our view: A dynamic portfolio that gradually adjusts the asset allocation towards the target date and that the risk is in line with the investor risk profile. Financial service providers have developed “target dated funds” or “fixed-maturity funds” that follow such logic. We find that such products add value especially in the context of saving for retirement or other big-ticket financial goals with a clearly defined target date that is difficult to adjust. Unfortunately, such investment products are silent over the expected investment return and hence make it difficult to know how much money one should actually invest to reach a certain goal. In addition, they by definition target a larger group of investors, and will therefore not be personalized to an individual situation.
FINANCIAL LIFE GOALS: Dynamic asset allocation at the core
The FINANCIAL LIFE GOALS investment engine addresses these shortcomings and finds the optimal investment portfolio and how the portfolio should dynamically change towards the target date. The dynamic asset allocation also known as a portfolio “glidepath” can be understood as a roadmap for changing the portfolio over time. With the glidepath, we can simulate how our portfolio value will evolve, the expected return and the distribution of wealth at the target date.
Besides the planned de-risking a portfolio allocation will also change due to
- regular rebalancing towards the target allocation
- changes to the long-term outlook of the asset classes (capital market assumptions)
- changes of the financial goal such as revising the target date of the goal, the amount needed, or the investor’s risk appetite.
Example: Sonja the dentist
Let’s take a look at a concrete example. Sonja is a 50 year old dentist from Zurich, Switzerland. Sonja is married and has two kids. Sonja wants to retire at the age of 65 and she requires CHF 5000 per month (inflation-adjusted) for living well in retirement. Sonja feels comfortable to take some investment risks but does not want to jeopardise her retirement. Her retirement goal can be described as:
- Target date: 2034
- Target amount: CHF 750 000
- Aspirational target amount: CHF 800 000
- Initial capital invested: 200 000
- Monthly savings towards goal: CHF 1700
- Risk profile: Medium
Given this information, the FINANCIAL LIFE GOALS investment engine optimises robust portfolios and calculates the glidepath that is shown in the chart below.
Sonja’s optimal portfolio has substantial equity risk at the onset as the time horizon until retirement is long. As the time to retirement draws closer, the equity portion of the portfolio decreases over time. In the year prior to retirement, the majority of Sonja’s money is invested in safe assets such as government bonds and cash.
Based on the glidepath, we can run a simulation to get an understanding of the future returns of our dynamic portfolio. For instance, the distribution of Sonja’s wealth after five years and at the target date is shown in the charts below and we can infer the expected returns for various levels of risk.
The below chart illustrates the probability of a certain wealth level. By having a dynamic asset allocation that de-risks the portfolio towards maturity, the wealth distribution at the target date will be skewed to the right. Or put in another way: the risk of a low wealth outcome is by construction less likely. For Sonja, there is a 80% likelihood that she will have more than CHF 600 000 at retirement.
Summary
If you are a private individual looking to invest for a long-term goal with a defined target date, you are well advised to change the investment portfolio over time to avoid the risk of being over-exposed to risky asset classes shortly before you require the money. Also, challenge your financial advisor and demand a well-defined roadmap for adjusting your asset allocation over time and what you can expect in terms of investment returns.
If you do not have access to a financial advisor with the ability to provide such personalised advice, consider some ready-made products that automatically de-risk the portfolio.
If you are a financial institution that wants to learn more about how you can provide dynamic asset allocation advise to your clients, then please get in touch with us.
This article was written jointly by Mark Andersen, Bernhard Obenhuber and Nicolas Camenzind. We will be excited to hear your thoughts on our series of investment notes. Contact us anytime via contact@financial-life-goals.com or have a look at our website at www.financial-life-goals.com
ABOUT: The FINANCIAL LIFE GOALS investment API
The FINANCIAL LIFE GOALS API provides access to the investment functionality described in this note. Feel free to reach out on contact@financial-life-goals.com for a further discussion. The FINANCIAL LIFE GOALS API is a product of SWISS FIN LAB.
