Portfolio design is about mitigating risks. Many people invest so as to have enough money to support themselves in retirement. When looking at this within the context of risk mitigation, this serves to mitigate the risk of running out of money in retirement.
However, a range of other risks need to be considered when designing a portfolio that similarly affects one’s likelihood to have enough money to last through retirement — idiosyncratic risk, concentration risk, behavioural risk, and currency risk are some of the bigger ones.
While we can’t eliminate all risks, there are ways to balance many of the risks to reduce the chance of any single risk becoming catastrophic, and some of the risks can be removed altogether.
A sound portfolio is built on a foundation of risk mitigation.
A. Longevity risk
As we saw previously, to live off our investments, we’re going to have to find something that has a higher return than risk-free asset classes like fixed-term deposits, and this is where having an allocation of equities come in. You don’t need it to be all equities, but you need to bear some risk – enough to provide a return that meets your needs.
Use growth assets (equities) to mitigate longevity risk and inflation.
B. Risk of a sustained market decline when you may need cash
Recessions happen. Suppose you have 100% of your money in equities, and a recession hits, and you lose your job at the same time that the stock market is down. In that case, you may need to sell shares at a loss instead of being able to wait until they recover, leaving you with a permanently depleted portfolio. Each of the below factors increases your need for more safe assets in preparation for market volatility.
- The older and wealthier you are, the less you’re able to save and recover from market losses.
- The less secure your job, the more safe assets you need so that you can survive longer if you’re unable to find work.
- Having dependents needing support during market declines lowers your ability to take on as much stock market risk.
- Renting or having a mortgage means you have more liabilities to support during a market decline.
- If you’re frugal, you have less discretionary spending to cut back on during a rough patch.
Even without a recession, just having a significant market decline and some bad luck can do the same kind of damage. As someone posted on mrmoneymustache.com –
I’ve had several emergencies in my life. Fire consuming every single possession except the clothes I was actually wearing; accident writing off my car and giving me whiplash for three years, causing a lot of time off work (and I fell through the cracks in insurance); job loss… You are often eligible for some compensation, but you may need emergency funds to cover extra, and to cover immediate requirements.
Don’t take on more market risk than you can financially tolerate.
Use safe assets (bonds) to avoid having to draw down your equities in a sustained bear market.
C. Emotional/behavioural risk
This is one of the most significant risks to your portfolio. Imagine spending decades saving your nest egg of a million dollars and steadily seeing the value of your life savings drop down to $850,000, $750,000, $650,000, $550,000, and now nearing $500,000. You don’t know how much more it will continue dropping, or if it will be a decade or more to recover (this had happened before). At some point, most people panic and sell out of the risky assets into risk-free assets, crystallising the losses and ensuring they will not recover. It’s human to panic. In the calm of today, you might think you will be able to tough it out but going through it is a whole other thing.
How do you mitigate this risk?
The simplest way is to imagine how you would feel if you saw your portfolio drop by specific amounts and determine as best as possible at what point you will likely panic. Don’t use percentages — you need to use actual dollar amounts based on your current portfolio value when imagining it. Once you have an estimate, you double that maximum tolerable loss and keep no more than that much in equities.
For example, let’s say you have $750,000, and you think you could tolerate seeing it go down to $500,000 but not below that. Your maximum tolerable loss is $250,000. You would then put no more than double that ($500,000) into equities and keep the rest ($250,000) in safe assets (bonds). Then in a severe bear market where equities drop 50%, you would have lost half of the $500,000 in equities and still have your $250,000 from your safe assets, so your total portfolio has only dropped from $750,000 down to $500,000 (33%) even though the equities market has fallen 50%. Not only will your portfolio value drop less, but you will recover faster since it has less to climb back up.
Use safe assets (bonds) to dial up or down your overall portfolio’s risk based on your ability to emotionally tolerate market risk.
Further reading:
Asset allocation and your risk tolerance
Math vs. Emotion
Just a general comment about “too conservative” investors here
D. Currency risk.
There are two currency risks.
Home currency upside risk
Home currency upside risk is where you have an all global portfolio, and your home currency rises against the world’s currencies. An example of this was from 2000 to 2011, where the Australian dollar more than doubled vs the US dollar, which means compared to an AUD currency hedged fund, it would have had half the value, and almost two decades later, it is still 1.5x what it was in 2000.
Home currency downside risk
Home currency downside risk is where you have an all home-currency based portfolio, and your home currency loses ground vs the world’s currencies’ — basically, the opposite of the above.
To mitigate currency risks, we want both AUD based assets and non-AUD (global) based assets.
E. Concentration risk
So far, we have split assets into risky assets (equities) and risk-free assets (bonds), and then to mitigate currency risk, we split our equities into AUD-based and non-AUD based (global) assets.
Bonds
Equities
• Non-AUD based equities
• AUD based equities
The typical starting point to mitigate both currency risks is 50/50 Australian equities / global equities.
But having half of your equities in the Australian market poses a lot of concentration risk.
The Australian stock market makes up just 2.5% of the world’s markets by cap weight (company valuation proportions), and the Australian market has half its entire value in just ten companies and two sectors.
Despite Australia’s freak occurrence of not having one for 28 years, recessions are a normal part of the economic cycle happening around about every decade or so.
The problem with too much of your assets in Australian equities is that when there is a recession, your property value, job stability, and now your stocks are all going to go down together because you have everything concentrated within the Australian economy. At a time when unemployment rises and lay-offs become more common, it’s difficult to find even lower-paying jobs, and your finances will have dropped, meaning if you need to tap into it, you’re tapping in when it is priced lower, depleting more of your assets and faster. You don’t know if it will last for a year or two years or five years or more and how many years of your savings are being wiped out as you struggle to survive financially.
Luckily, we have another option besides Australian equities – global equities hedged into Australian dollars.
So the simple solution is to replace some or all our Australian equities with global AUD-hedged equities.
For example:
Non-AUD equities
50% global equities
AUD equities
25% Australian equities
25% global equities AUD-hedged
This gives you half your equities in AUD to balance both currency risks, but only 25% of your total equities are in the concentrated Australian market.
You can vary the ratio of the last two items.
- Australian equities have concentration risk, but you get franking credits.
- Global AUD-hedged equities avoid concentration risk, but you get no franking credits.
So if you think 35% in Australian equities is still an acceptable concentration risk, you might make it 35/15. Or, if you want to avoid concentration risk altogether, you can remove Australian equities and make the AUD portion entirely global AUD-hedged equities. You miss out on franking credits, but you may be able to save a little more, retire a bit later or spend a little less in retirement. This option leaves you with a complete solution — no concentration risk, a good balance between upside and downside currency risks, and any drag on returns from missing franking credits is taken care of by other means.
Also, note that franking credits don’t give you as much of a benefit as you think, so that should be taken into consideration.
Mitigate concentration risk by buying mostly global equities instead of being narrowly focused on Australian equities.
Mitigating risks through other means
Besides mitigating risks through diversification of asset classes (both stocks and bonds), diversification of markets (all 23 developed countries and 23 emerging markets), and diversification of currency (both AUD based assets and non-AUD based assets), there are other means of mitigating risks, namely saving more.
This can be by
- Investing your time or money in improving your earning prospects.
- Saving a higher portion of your income.
- Saving longer (retiring a little later).
- Picking up a side gig like dog walking or part-time consulting.
- Avoid upgrading your house unless it’s necessary, or consider an older house and renovating it yourself.
- Buying a 3-year-old car instead of a new car.
If you can accumulate a little more or spend a little less, you can entirely remove the concentration risk of Australian equities. As a result, you can lower your market risk with a higher allocation of safe assets and still meet your needs. After all, wealth accumulation is not a goal; it is a means of achieving a goal – financial independence – and we should attempt to meet that goal while minimising risks as much as possible.
In summary
- Use low-cost broad market index funds to remove idiosyncratic risk, fund manager risk, and the drag on returns from active fund managers.
- Use growth assets (equities) to mitigate longevity risk and inflation.
- Use safe assets (bonds) to dial up or down portfolio risk based on your personal risk tolerance.
For your growth assets (equities)
- Use both AUD and non-AUD based assets to mitigate upside currency risk and downside currency risk.
- For your non-AUD based assets, use a global index fund to avoid concentration risk.
- For your AUD based assets, choose a mix of Australian equities and global AUD-hedged equities based upon concentration risk vs franking credits.
That might sound complicated, but we can implement all these with just a few index funds.
Fixed income
Bond index fund
Equities
Global index fund
Australian index fund and/or AUD-hedged global index fund
In the following articles, we’ll put it all together, going through the funds and finally the decision points on how to personalise the proportions between them.