Notice how quickly the commentary from numerous money managers has shifted away from quoting so-called “risk adjusted performance.” This shift is a clear sign of two different stances. The first is after seven or eight weeks of rising stock prices, many are identifying the current surge as a rising market. Because we have not topped the historic highs of 2007, few are calling this a new bull market. But they are directing their attention almost exclusively to rising rather than falling prices for stocks and bonds in most markets around the world. From a market standpoint it is almost like shouting, “The king (of the bear market) is dead. Long live the new king (of not yet the bull market).”
Intellectual Dishonesty or “They Should Have Known Better”
To me, the second stance that becomes evident from the dropping of the risk adjusted handle is intellectual dishonesty. This strong statement indicts not only many managers but also their marketing people and many academics. The fallacy started in academia, as finance and investment teachers with their reliance on mathematical formulas wanted to balance potential rewards with potential risks. The problem is that risk is the uncertainty of loss. In their 50 minute lesson-plan world they latched on to the volatility of price movements over a rolling 36 month period. If a stock or a fund had a wider than “normal” variance to the trend of prices or adjusted net asset values it was deemed to be more risky than one that hugged the central tendency line more closely. Thus, index funds are by nature less risky than actively managed aggressive funds. The practice started of adjusting absolute returns by these volatility factors to develop “risk adjusted returns.” These numbers appealed to various consultants and other gate-keepers because they generated a selection screen that eliminated the wild performers. The problem with these exercises is that they had nothing to do with actual risk. The purveyors of these numbers knew or should have known that risk adjusted results had nothing to do with real world risks.
What is Risk?
From an investor's viewpoint, risk is the penalty for being wrong in the future. To me as an investor, investment advisor, and a member or chair of non-profit investment committees, risk is the inability to pay for planned and vital expenditures. In the real world risk is different for each account. For some Ultra High Net Worth investors, risk is all about running out of funds for the fourth generation or the new wing to the hospital (which is likely to be one’s last used medical facility).
There Are Two Risks
In assessing the elements of risk identified above, there are really two risks. The first (and of paramount importance) is running out of cash to accomplish the critical mission. The fourth generation will have to become working stiffs (which could be a good thing compared to their third generation parents); or the new wing will be delayed until other sources of funding are secured; or the hospital or university will be forced to scale back, merge, or close. (Perhaps if the potential patients or students won’t support the expansion, once again the wisdom of the marketplace could be correct compared with a donor’s wishes.) The second risk is not running out of funding, but the more likely outcome of not earning a high enough rate of return to accomplish the planned goal in a timely fashion.
Managing Both Risks on a Time Horizon
The simplest way to handle the risks is to have the investment side control the granting side. One of the foundations that we have managed money for years has largely limited its grants to other charities to the capital earned by the charity in the prior year. Politically that is not how most pots of money are run. In reality, the operating or granting side determines what it wants and the investment side concurs if the spending rate is reasonable in light of the time horizon of its mandates. Most wealthy families or endowments believe that their responsibilities are never ending thus they see their funds need to remain in place forever. Others actually plan (or would allow themselves) to, in effect, die. This extreme, and perhaps irresponsible attitude can be summed up as “expending the last dollar with the last breath.”
A further constraint on managing the twin risks is the importance of planning the time horizon. Actually the addition of a time horizon can make it easier to manage risks.
With a great deal of conversation and work with clients, and even more with investment committees, I try to attach to each planning goal time to completely identify the goal with the client. Even more difficult is to array the various goals in some sort of priority setting. The next step is to determine whether the client wishes to intellectually fund each goal until the capital runs out. In setting the investment returns for each of the goal-oriented portfolios (assuming that the intention is to have the capital last forever), I use the following rules of thumb:
- If the account is a tax exempt account, a payout ratio of total return income to capital of 4% is reasonable.
- For a taxable account, a maximum payout ratio might be 3%. In both cases I would reduce the ratios if long-term inflation is expected to be higher than these ratios.
- For accounts with a limited life or if the account was a beneficiary of new cash flow, somewhat higher spending ratios would be appropriate as long as the net cash flow continues.
- For investments in equities, whether in the form of individual stocks, funds, private equity or hedge funds, I would expect over time the returns would be between 50% and 75% of the net cash generated by taxable entities.
- In terms of fixed income, on the very highest-quality paper, yields to maturity might be appropriate if the account could hold the paper until maturity. More specific fixed income approaches are very much account dependent.
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I want to stay current with my grandchildren, grandnieces and grandnephews as eventually they will become the clients that will benefit from my work.
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