Sunday, March 15, 2015

Portfolio Benchmarks and Lifestyle Risk

The Total Return Fallacy
The financial industry, in my opinion, is big on hyping a portfolio’s total return, which includes both price appreciation and dividends payments, as the end-all metric for monitoring portfolio performance. Rarely I do hear “risk” mentioned in the same sentence. Any portfolio return is meaningless if you don’t understand the risk taken to achieve it in my humble opinion.

The short-term measure of portfolio risk is standard deviation, also known as “volatility”, which tracks the price fluctuations of the underlying securities in the portfolio. Fortunately, more and more performance reporting systems used by advisers are providing “risk-adjusted” total return statistics on your portfolio. The most common measure is the Sharpe Ratio, named after its creator Stanford economist Bill Sharpe. If you are not reviewing your portfolio’s Sharpe Ratio or an equivalent risk-adjusted measure on a regular basis, you should be.

The Unhelpful Benchmark Comparison
To make matters worse in my opinion, many portfolio return benchmarks used for performance comparisons are not risk-adjusted either. So while your portfolio return beat its reported benchmark, that may be of little comfort if your portfolio lost 40% of its value during the great recession of 2008-2009.

The first step is to use “risk-adjusted” returns and benchmarks where possible. Given Koch Capital utilizes four distinct investment objectives—Longevity Coverage, Capital Growth, Steady Income and Cash Reserve, we start with the basic premise of measuring the amount of return per unit of risk taken. If your investment goal is to have your portfolio do well in inflationary periods to help protect against longevity risk in retirement, then it’s helpful to know the portfolio’s real return (nominal minus inflation) adjusted for risk.

Likewise, if your goal is to provide steady, consistent income, then Koch Capital recommends monitoring the risk-adjusted yield of the portfolio. And if your goal is to maintain a safe, liquid cash reserve for emergencies, then the only measure that counts, in my opinion, is “will you permanently lose capital during the next major financial crisis”.

Source: Koch Capital

For more information on our Investment Roadmap approach shown in the diagram above, please watch this educational video which helps investors think about how to focus their investment objectives on meeting future retirement needs.

Think Long-Term Risk
While younger investors may be able to tolerant significant market gyrations, investors nearing retirement don’t have that luxury when planning for portfolio withdrawals to fund retirement. They need to understand the long-term consequences before they act.

When taking regular distributions from your investment accounts, your portfolio becomes more sensitive to short-term market volatility. The short-term market volatility becomes a long-term funding problem if you (1) actually take a withdrawal from your portfolio when it’s significantly down in value—this is known as sequence of return risk—or (2) make a rash, irrational investment decision like selling your entire portfolio at the market bottom.

A solid financial plan will prevent you from making either of these two classic investor mistakes. To learn more about Koch Capital’s approach to protecting your retirement goals from risky investments, please watch this educational video.  

Thank you for your consideration.......Jim

About Jim Koch
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to advisors, individuals, families, trusts and business entities so they are better able to achieve their goals. Jim sees himself as an "implementer" of financial innovation, using state-of-the-art technology to provide practical investment management and retirement income planning solutions for clients.

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