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When most investors think about “risk reduction” their minds immediately conjure volatility and losses. We cover strategies and products for downside protection at length in our discussion with clients. However, as advisors we should consider a broader definition of risk that connects more directly to how clients feel about their investments. Specifically, advisors should define risk as the probability that clients won’t meet their financial goals. Advisors should have the singular objective of minimizing this risk.

This new definition of risk profoundly shifts the conversation away from volatility and losses, and toward strategies that also achieve minimum required returns. From this new perspective, it is not sufficient to manage risk and provide downside protection; an investment strategy must also produce returns that fulfill long-term goals. Moreover, the strategy must account for the fact that investors are susceptible to shorter-term dynamics, such as tracking error relative to domestic benchmarks, which may run counter to the objective of long-term wealth maximization. In other words, advisors need to build portfolios that are financially optimal, but that investors can stick with over time.

This is not a trivial undertaking. The current environment presents unique challenges that make it extremely difficult to engineer a traditional portfolio with expected long-term returns that are consistent with client objectives. Advisors must look to alternative sources of return to fill the gap, but this presents a different complication. These alternative sources of return will behave very differently than what clients are used to. They also come with large tracking errors to typical benchmarks. As a result, clients run a high risk of abandoning these strategies before they have a chance to perform.

Realistic expectations

First, let’s examine why traditional portfolios are unlikely to produce sufficient returns. Expected bond returns are least controversial, so let’s start there. The weighted average yield-to-maturity for the widely held iShares U.S. Aggregate Bond Index ETF is 2.55% net of expenses, with a weighted average maturity of eight years. The Barclays Global Aggregate yields just 1.66%. This is a good proxy for the actual return that investors in this fund might expect over the next decade or so.

What about stocks? Let’s start with an unbiased assumption that the equity sleeve of a typical investment portfolio will earn the historical long-term excess return of a globally diversified equity portfolio. Global equities have produced compound returns about 4.2% above T-bills over the long-term, and 3.2% above 10-year Treasury bonds[1]. T-Bills currently yield about 0.5% and benchmark Treasury bonds yield 2.35%, suggesting that a diversified stock portfolio should earn nominal returns between 4.7% – 5.5% over the next decade or so. Let’s assume 5.5% to err on the side of optimism.

This means that the most an investor can likely expect from any unlevered traditional portfolio is 5.5% per year over the next 10 years or more. To achieve 5.5%, you need to own a pure equity portfolio, with all of its accompanying risks. A traditional 60/40 portfolio will produce about 60% * 5.5% return + 40% * 2% return = 3.3% + 0.8% = 4.1% nominal. And that’s if we are being optimistic.

Unfortunately, there is not much reason for optimism. Stocks are expected to produce an average excess return only when they are priced near average valuations. But many stock markets are currently quite expensive. U.S. stocks, which represent over half of total global stock market capitalization, are trading near record valuations according to some measures. For example, U.S. stocks are trading near their 2000 bubble peak as a multiple of total revenues (Figure 1). Should stocks retrace to average valuations by this measure in an acute correction, investors would endure a 48% decline. If they were to mean-revert over a longer horizon, they would face a material headwind on long-term returns.

Figure 1. S&P 500 Index and Price-to-Sales ratio, 1955-2016

Risk Reduction

Source: Ned Davis Research

Risk

By Adam Butler, read the full article here.