Risk control is a primary function of any sound investment process. Yet when we look at a household’s Whole Picture, we often see a family’s largest risk is not hidden in their investment portfolio. It’s not whether their asset mix is 80% stocks or 80% bonds. It’s not defined by a standard deviation or the 5th percentile outcome in a Monte Carlo analysis.
Rather, it is a private business, concentrated real estate or future compensation from a lucrative career (i.e. human capital.) In good times, these exposures provide (often substantial) annual income. But in bad times, the cashflows can dry up or head to zero. The impacts can be material and, far too often, we leave these risks unaddressed.
We’re a naturally overconfident lot, us homo sapiens. So we tend to not believe anything bad will happen to these exposures. This confidence is strengthened by the representative heuristic, a mental shortcut that forms probabilities based on a limited sample size of personal experience. But just because you or I haven’t witnessed a bad event doesn’t rule out its possibility. As Stanford Professor Scott Sagan said, “Things that have never happened before happen all the time.”
Given the magnitude of an acute disruption of income, we recommend clients form a Protective Reserve of liquid, comparably safe assets. The primary purpose of a Protective Reserve is to offer households a buffer to navigate such unforeseen distress. But instead of allocating based upon a percentage of a portfolio, we size this allotment to cover a preselected period of spending. As a result, the family doesn’t have to immediately cut lifestyle choices like children’s schools or downsize a primary residence.
Households can choose to allocate funds equivalent to a few months or several years of their expenses to protect against unexpected hardships. Several factors influence the sizing of the Protective Reserve. While we work with each household to develop a custom Protective Reserve for their unique circumstances, here are some quick considerations:
Income Concentration – Households whose income comes from one source (i.e. single wage earner) will need to cover a longer period of spending to replace lost income, all things equal.
Economic Sensitivity – Households whose income is more susceptible to distress during poor economic times likely will have a larger reserve.
Spending Flexibility – households with larger fixed costs will need a comparably longer period of covered spending.
Since these shocks often coincide with recessions and economic slowdowns, the Protective Reserve has an added benefit of cushion for economic bad times, right when the remaining Growth Assets are likely to be falling in price. Liquidity and accessibility are key. For this reason, we typically recommend money market instruments and high-quality short-term bonds in taxable accessible accounts.
In essence, a Protective Reserve serves as a safety net, minimizing the repercussions of unforeseen adversities, be it to the economy at large or a household’s individual circumstances. It offers a reprieve for a household to recover lost income.
By defining the Protective Reserve according to each household’s unique risks and spending, we allow the remaining portfolio (i.e. Growth Assets) to be more aggressively invested. The sizing of our low risk/recessionary investments is tied to consumption, not portfolio value. As a household’s financial resources grow, we’re not automatically allocating more and more to safer investments (like money market funds) and their comparably lower returns (especially after taxes.)
Charles D. Ellis, one of the great financial writers of our time, suggested that long-term investment success is really about not suffering big losses.
“While all the chatter and excitement is taking place about big stocks, big gains, and “three-baggers,” long-term investment success really depends on not losing—not taking major losses….If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves.”
We agree. And believe a well-suited and appropriately invested Protective Reserve is a critical first step in building resiliency to weather the unforeseen – inside and outside your investment portfolio.
Moving to current markets, the yield curve remains “inverted”, where short-term bonds yield more than longer-term bonds. This has historically signaled economic recessions. While it doesn’t guarantee tough economic times ahead, it may be a good nudge to assess your household’s Protective Reserve allocation. Let us know if you would like to discuss.
Markets fluctuate. Priorities change. We’re here to help.
References
- A great example of representative bias is Malmandier and Nagel, which found that investors who grew up in the Depression systematically underinvested in the stock market. They found a similar result when examining investors that lived through poor returns from bonds, subsequently investing less in bonds. Ulrike Malmendier, Stefan Nagel, “Depression Babies: Do Macroeconomic Experiences Affect Risk Taking?”, The Quarterly Journal of Economics, Volume 126, Issue 1 (2011): Pages 373–416.
- Charles D. Ellis, “Investing Success in Two Easy Lessons”, Financial Analysts Journal, Volume 61, Issue 1 (2005):Pages 27-28.