A retired client and I pursued an investment planning process using this risk management strategy. We identified his major risks as inflated living expenses and potential long-term care liabilities. We allocated a portion of his portfolio for inflation protection and anticipated a long-term and significant drop in equity values (a five-year decline and a drop of 50%). Even under those conditions, he still had sufficient assets to protect against most worst-case liabilities.
After taking into account these risk scenarios, we found ourselves with an asset allocation very different from what the standard age-based model would have proposed. In this case, the client preferred to take more investment risk than an advisor would normally recommend. But given the potential bad outcomes and his acceptance of those risks, the portfolio offered a higher expected return for his estate, which was his priority after he'd allocated adequate assets to cover his future liabilities.
In this case, we did not consider the potential loss of Social Security income as a risk. It could be, unfortunately, that someday we have to.
In the institutional world, risk management is an integral part of money management. But individual investors mostly manage their risk implicitly, using insurance and some portfolio diversification. Instead, they could be segregating their non-insurable future liabilities and mitigating their risks separately by matching their assets to highly correlated obligations.
With the advent of exchange-traded funds and notes for currencies, commodities and other alternative asset classes, it is now possible to perform risk management of this sort for individuals. But risk management also means focusing on all the cataclysms a person faces in life, not just his investment risks. Understanding and planning for these risks and their potential correlations is just as important in the investment process.
Michael J. Reed is president of M.J. Reed Investments, a Bridgewater, Conn.-based RIA firm. He was a former director in Morgan Stanley's Process Driven Trading unit.