March 12, 2012: Setting The Right Risk Profile
03/13/2012 0 comments
Re-balance Cycle Reminder
Based on our new monthly re-balance calendar, the next re-balance time will be on next Monday, March 19, 2012. You can also find the re-balance calendar of 2012 on 'My Portfolios' page.
As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.
Setting The Right Risk Profile
Similar to your physical health risk profile, risk profile in an investment process is one of the most important factors for your financial health. Understanding the concept correctly and use it consistently are often the two most FAQs from our users.
Personal Risk Profile or Portfolio Specific Risk Profile
Risk profile can be for your overall personal financial risk tolerance or portfolio specific. In general, everyone has an overall risk tolerance and growth expectation for his/her investments. Deciding an overall personal level risk profile is a function of two parameters: when you will start to access the capital for retirement and your personal risk tolerance. In our system, similar to those offered by target date funds, we have a simple utitlity to help you to decide this. But remember this is just a starting point: one should refine that and do some scenario analysis for any number derived.
A personal level risk profile can help to decide asset allocation of your overall investments if you aggregate all of your investments such as 401K accounts, IRA accounts, brokrage taxable accounts and bank accounts in one portfolio.
Many rules of thumb exist in deciding personal risk profile such as John Bogle's 100-age as stock allocation (thus, you age would be our risk profile). For example, a 45 year old would have risk profile 45, meaning in his overall investments, at least 45% should be in fixed income 'safe' assets.
Unfortunately, because there are inflexibility and expectations for various accounts, one can break down the investments into many portfolios, each portfolio would have a specific risk profile.
A well known retirement investment strategy called 'buckets of money' proposed by financial advisors such as Ray Lucia would divide your investments into 2 or 3 buckets. The first bucket should be cash and ultra short term investments, for the purpose of immediate use up to 2 years (depending on whether you are pre or in retirement). The second bucket are the investments that would be accessed in 3-10 years. Finally, the third bucket are the long term investments that will be only accessed 10 years or so. The buckets are thus of different risk profiles.
Other situations calling for portfolio/account specific risk profiles include college funds for kids and major events in near or intermediate terms.
Each portfolio at MyPlanIQ can be customized using different risk profile.
Risk Profile and Strategies
One of the most misunderstood concepts in risk profiles is its relationship with investment strategies. Often, users would state that since Tactical Asset Allocation(TAA) has lower standard deviation/max drawdown than that in Strategic Asset Allocation(SAA), they would increase their risk profile for portfolios using TAA. In our opinion, this is an incorrect way to use risk profile and strategies. A investment strategy, regardless how well it has performed in the past (real life or back tested), is subject to similar risk in extreme scenarios. For example, a TAA portfolio with 0 risk profile can be 100% invested in stocks at some period of time. Since there is no way for one to prevent sudden stock market crashes, the portfolio can be subject to as big as the loss in short amount of time as an SAA portfolio. Investors should be fully aware of all possible scenarios.
To reiterate, risk profiles should be independent of investment strategies used. They are really meant for capital access timing and risk tolerance.
Risk Profile and Markets
The other similar misuse/misconception of risk profiles is that investors are mistakenly carried away by current market states and change their risk profiles based dynamically. For example, when stocks are rallying, it is easy for one to think bold and forget inherent risks (in fact, quite to the contrary, when stock prices are at elevated level, they are more expensive and thus riskier to hold) and increase his risk profile.
Similarly, in a severe bear market, investors become extremely risk averse and start to scale down his risk profile. All of these actions are precisely opposite to what should have been done correctly: maintain your predecided (and true) risk profiles regardless of where the markets are.
The above brings up an important point we have stressed many times: correctly setting up your risk profile is paramount.
They should not be decided based on prevailing market conditions.
Portfolio Reviews
The following compares one of our featured TAA and SAA portfolios with two funds: Cambria Global Tactical (GTAA) and Goldman Sachs Dynamic Allocation (GDAFX):
Portfolio Performance Comparison (as of 3/12/2012)
| Portfolio/Fund Name | YTD Return | 1Yr AR | 1Yr Sharpe | 3Yr AR | 3Yr Sharpe | 5Yr AR | 5Yr Sharpe |
|---|---|---|---|---|---|---|---|
| GDAFX | 4% | 1% | 12% | ||||
| GTAA | 3% | -6% | -62% | ||||
| MyPlanIQ Diversified Core Allocation ETF Plan Strategic Asset Allocation Moderate | 6% | 3% | 19% | 18% | 154% | 6% | 29% |
| MyPlanIQ Diversified Core Allocation ETF Plan Tactical Asset Allocation Moderate | 4% | -1% | -20% | 10% | 86% | 10% | 77% |
Market Reviews
U.S. stocks continued to be at elevated levels, budging very little last week. All other stock indices fell, with commodities and gold being the weakest. See major asset trend table on 360° Market Overview for more details.
We still maintain that risk is high at the moment. For new investors, it is especially important to adopt gradual exposure to risk assets using strategies suh as dollar cost averaging.
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