Note: my article was posted on and promoted on the main CFA website and twitter accounts (here, here). Additionally, "Great article by Salil Mehta" claims SkyBridge Capital CEO & Fox Business News distinguished co-host (w/ Maria Bartiromo) Anthony Scaramucci. Please read the information (in grey text color) below this article, for more nice news.
What is the optimal amount of risk a client should have in their portfolio throughout their career?
This is not an easy question to answer, so it is not surprising that there are many different responses. Target date funds (TDFs) are, in theory, simple products that allow clients to focus on a single question: “How old am I?”
This data then roughly maps to their retirement age (e.g., a 40-year old has 25–30 years of career remaining), and the TDF automatically allocates risk to the fund along a predefined allocation mix appropriate for someone as they evolve toward retirement.
For example, most people generally appreciate that they want to take on less risk closer to retirement than during their younger days.
But the Funds Often Disagree with Themselves
In practice, an investor using an TDF is somewhat removed from having to think about and make short-term tactical decisions. TDFs automatically reallocate funds back to the predefined risk levels, which is helpful during extreme market moves.
This rebalance occurs only quarterly, however, which is not optimal. Extreme repricings of risk tend to last only weeks or months.
The key to a passive portfolio construction is to have a solid framework for what the overall most appropriate risk allocation should be.
We see from research, in addition to the mathematical idea that during retirement one places a higher utility on risk, that the function can be somewhat analogous to this estimated probabilistic expression:
Where adjusted-time is equal to years to retirement plus one half the years expected to live in retirement.
So someone 90% invested in risk at age 25 (with an expected retirement at 65 and total retirement of 18 years), would at age 65 show the following risk allocation level:
This optimal risk allocation, based upon the investor’s longevity and modeling uncertainty, provides for an allocation similar to what TDFs currently have. With (domestic) equities the largest risky asset in TDFs, one can see this concave-shaped result in the chart below.
Investments in cash and bonds mostly complement this.
The actual optimal path has a confidence interval around it, though what is most instructive here for our focus is on the general shape and location.
For example, we note that T. Rowe Price and the government’s Thrift Savings Plan (TSP) both under-allocate to equities (perhaps by 10% allocation) in one’s early wealth building years.
Fidelity and Vanguard continue to over-allocate to equities (by as much as 10%–15% allocation) as one is preparing to head into retirement.
Vanguard only gradually glides their risk down linearly, and it doesn’t accelerate their risk reduction in the concave shape that we show is optimal.
That TDFs differ from one another in so many ways suggests that there is no single variable assumption among them. Instead it is a mystery. For example, the difference among the TDFs is not as simple as one thing — say, the longevity risk assumption.
So this leaves a greater onus on investors to think carefully about the TDF that they select, since they are not just identical products with slightly different fees (the article linked here by the way is the second most popular in the CFA.)
So What Do You Do?
First, it is imperative for retirees to think about their end of life first. They might live longer than expected, and this is one risk we cannot diversify away.
Know also that they may not be financially employable or productive throughout the years until their expected retirement age. And while difficult, this assumption implies the need for an even greater savings cushion in retirement.
There are research and resources available for older Americans who may find themselves with diminished financial reasoning skills later in life. They should safeguard much of their allocation trajectory as soon as they are capable. As uncomfortable as it may be, it is better they confront their thoughts on your mortality now, and then plot their optimal risk path.
It is critical to remember that no one will be able to perfectly identify a specific and unwavering optimal risk path. And our unique situations are so complicated and different from one another that no one model will get it right for everyone.
The error and confidence interval around such estimates is high, so it is most critical to think about the optimal risk path only in terms of its general location and shape.
The reason for this uncertainty is that market and macroeconomic growth in any region is subject to considerable model and long-term growth forecast uncertainty, which impacts the abilities of wise central planners. In life we have to assume a middle path and consider TDFs in more retirement-oriented accounts (less subject to income cash-flow changes).
Even TDFs are not cemented in their philosophical views. The risky asset allocation away from bonds can be modified by the fund company too, as we currently see with the government’s TSP shortly after my prequel article here.
Other news: This article is was the top featured for over a week on a CFA website, and also cropped up on Seeking Alpha.
Our ISIL's psychotic ambitions article shared by Ritholtz. And our Smoldering markets article was a top article in Zero Hedge (under the title "'Something disquieting is afoot' for U.S. bond markets").
Also, there is a cool new BlackRock's Future Advisor book by Wiley! Comments by me, the recent head of Stanford's endowment, and the CEO of XL on the back.
This all brings me, close to year-end, to noting something random about how this blog has developed over 2015. I have written nearly 45 articles in both 2014, and again in 2015. And of my top 10 most read and shared articles: 4 were from 2014 and 6 were from 2015. To a naïve person, this is a sizable 50% improvement! But to active readers of this blog, we understand that the conclusion is a little deeper than that, since the sample size at the extremes is low and not independent (if we reduce the 6 for 2015 to 5, then there is some chance the 4 for 2014 would rise). The blog's performance reach is indeed an improvement, though not as much in a probabilistic sense. And we can consider the numerous run-away hits authored in other places outside of the blog (e.g., the CFA, Harvard's Statistics Department website, Pensions&Investments, etc.) Or 2015 articles in the print press that have included my insights, such as in The New York Times, or Businessweek.
Lastly, it is worth noting for anyone who missed it, which half dozen blog articles from 2015 so far, were among the most popular ever on Statistical Ideas (and drawing viewing traffic into the millions). Each has an interesting story, and have been enjoyed and shared by the most significant media (Financial Times, The Globe&Mail, NYT's Upshot, NPR, Barron's, CNBC, Wall Street Journal), to whom I am always appreciative. Some articles were also enjoyed by far-reaching people such as a prosecuting attorney in the Bill Cosby case, Deepak Chopra, Larry Summers, another board member of Lending Club, two U.S. Presidential candidates, Warren Buffett, a deputy to George Soros, leaders across many top hedge funds, and many others. Most of these I only know about through conversations with them or their public sharing of an article. Feel free to let me know if I missed anyone!
Check them out and share them, if you like:
What is the optimal amount of risk a client should have in their portfolio throughout their career?
This is not an easy question to answer, so it is not surprising that there are many different responses. Target date funds (TDFs) are, in theory, simple products that allow clients to focus on a single question: “How old am I?”
This data then roughly maps to their retirement age (e.g., a 40-year old has 25–30 years of career remaining), and the TDF automatically allocates risk to the fund along a predefined allocation mix appropriate for someone as they evolve toward retirement.
For example, most people generally appreciate that they want to take on less risk closer to retirement than during their younger days.
But the Funds Often Disagree with Themselves
In practice, an investor using an TDF is somewhat removed from having to think about and make short-term tactical decisions. TDFs automatically reallocate funds back to the predefined risk levels, which is helpful during extreme market moves.
This rebalance occurs only quarterly, however, which is not optimal. Extreme repricings of risk tend to last only weeks or months.
The key to a passive portfolio construction is to have a solid framework for what the overall most appropriate risk allocation should be.
We see from research, in addition to the mathematical idea that during retirement one places a higher utility on risk, that the function can be somewhat analogous to this estimated probabilistic expression:
Risk allocation * √(adjusted-time remaining)
Where adjusted-time is equal to years to retirement plus one half the years expected to live in retirement.
So someone 90% invested in risk at age 25 (with an expected retirement at 65 and total retirement of 18 years), would at age 65 show the following risk allocation level:
90% * √[(18/2)/(40+18/2)]
~ 90% * √[(9)/(49)]
~ 90% * 43%
~ 39% risk allocation
This optimal risk allocation, based upon the investor’s longevity and modeling uncertainty, provides for an allocation similar to what TDFs currently have. With (domestic) equities the largest risky asset in TDFs, one can see this concave-shaped result in the chart below.
Investments in cash and bonds mostly complement this.
The actual optimal path has a confidence interval around it, though what is most instructive here for our focus is on the general shape and location.
For example, we note that T. Rowe Price and the government’s Thrift Savings Plan (TSP) both under-allocate to equities (perhaps by 10% allocation) in one’s early wealth building years.
Fidelity and Vanguard continue to over-allocate to equities (by as much as 10%–15% allocation) as one is preparing to head into retirement.
Vanguard only gradually glides their risk down linearly, and it doesn’t accelerate their risk reduction in the concave shape that we show is optimal.
Example of Stock Allocation Relative to Retirement Year
That TDFs differ from one another in so many ways suggests that there is no single variable assumption among them. Instead it is a mystery. For example, the difference among the TDFs is not as simple as one thing — say, the longevity risk assumption.
So this leaves a greater onus on investors to think carefully about the TDF that they select, since they are not just identical products with slightly different fees (the article linked here by the way is the second most popular in the CFA.)
So What Do You Do?
First, it is imperative for retirees to think about their end of life first. They might live longer than expected, and this is one risk we cannot diversify away.
Know also that they may not be financially employable or productive throughout the years until their expected retirement age. And while difficult, this assumption implies the need for an even greater savings cushion in retirement.
There are research and resources available for older Americans who may find themselves with diminished financial reasoning skills later in life. They should safeguard much of their allocation trajectory as soon as they are capable. As uncomfortable as it may be, it is better they confront their thoughts on your mortality now, and then plot their optimal risk path.
It is critical to remember that no one will be able to perfectly identify a specific and unwavering optimal risk path. And our unique situations are so complicated and different from one another that no one model will get it right for everyone.
The error and confidence interval around such estimates is high, so it is most critical to think about the optimal risk path only in terms of its general location and shape.
The reason for this uncertainty is that market and macroeconomic growth in any region is subject to considerable model and long-term growth forecast uncertainty, which impacts the abilities of wise central planners. In life we have to assume a middle path and consider TDFs in more retirement-oriented accounts (less subject to income cash-flow changes).
Even TDFs are not cemented in their philosophical views. The risky asset allocation away from bonds can be modified by the fund company too, as we currently see with the government’s TSP shortly after my prequel article here.
Other news: This article is was the top featured for over a week on a CFA website, and also cropped up on Seeking Alpha.
Our ISIL's psychotic ambitions article shared by Ritholtz. And our Smoldering markets article was a top article in Zero Hedge (under the title "'Something disquieting is afoot' for U.S. bond markets").
Also, there is a cool new BlackRock's Future Advisor book by Wiley! Comments by me, the recent head of Stanford's endowment, and the CEO of XL on the back.
Given rate rise anxieties earlier this month, our Rate rise pandemonium article was also shared >200 times on social media, including by Ritholtz, and on Zero Hedge. And our Travel post-ISIL article was a top read in Zero Hedge (under the title "American tourism in the age of terrorism").
My "Market risk; model smash" article was singled out as one of the top finance articles in 2015. enjoyable article concerning the probability of market patterns, coming out of initial market declines. was shared >300 times to date.
This all brings me, close to year-end, to noting something random about how this blog has developed over 2015. I have written nearly 45 articles in both 2014, and again in 2015. And of my top 10 most read and shared articles: 4 were from 2014 and 6 were from 2015. To a naïve person, this is a sizable 50% improvement! But to active readers of this blog, we understand that the conclusion is a little deeper than that, since the sample size at the extremes is low and not independent (if we reduce the 6 for 2015 to 5, then there is some chance the 4 for 2014 would rise). The blog's performance reach is indeed an improvement, though not as much in a probabilistic sense. And we can consider the numerous run-away hits authored in other places outside of the blog (e.g., the CFA, Harvard's Statistics Department website, Pensions&Investments, etc.) Or 2015 articles in the print press that have included my insights, such as in The New York Times, or Businessweek.
Lastly, it is worth noting for anyone who missed it, which half dozen blog articles from 2015 so far, were among the most popular ever on Statistical Ideas (and drawing viewing traffic into the millions). Each has an interesting story, and have been enjoyed and shared by the most significant media (Financial Times, The Globe&Mail, NYT's Upshot, NPR, Barron's, CNBC, Wall Street Journal), to whom I am always appreciative. Some articles were also enjoyed by far-reaching people such as a prosecuting attorney in the Bill Cosby case, Deepak Chopra, Larry Summers, another board member of Lending Club, two U.S. Presidential candidates, Warren Buffett, a deputy to George Soros, leaders across many top hedge funds, and many others. Most of these I only know about through conversations with them or their public sharing of an article. Feel free to let me know if I missed anyone!
Check them out and share them, if you like:
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