How Do You Manage Risk?
As I write, the U.S. stock market is flirting with all-time highs. All three major indices—the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite—seem to defy gravity. In aggregate, the stocks of these companies are trading at historically (and statistically) high prices relative to their earnings.
To the extent we depend on the whims of the stock market to fund our retirements, how vulnerable are we to a downturn?
History tells us corrections and bear markets are inevitable. So-called black swan events—think dot-com bust, subprime mortgage crisis, Covid-19 pandemic—seem to occur with ever greater frequency.
We know it’s coming. Will the next downturn be mild or severe; short-lived or secular? Whatever its duration or severity, will we be prepared to weather the storm when it comes?
Conventional Wisdom
Most of us subscribe to some extent to the conventional investing advice:
Invest in low-cost, broadly-diversified index mutual funds and ETFs. Pick a stock/bond allocation that accords with your risk tolerance. Sprinkle in some international exposure for added diversification. Rebalance annually to maintain the target allocation.
Sometimes It’s Not Enough
In 2022, following the pandemic crash and ensuing inflation, stocks and bonds both swooned. We had been taught that stocks and bonds are negatively correlated, thereby offering us some protection—when one goes up, the other goes down.
But that relationship didn’t hold in 2022. Even contrarians like gold and crypto plunged. It seemed no financial asset (with the notable exception of real estate) could escape the gravity of the post-pandemic swoon. If that weren’t enough, inflation took a big bite out of our purchasing power.
Fortunately, the markets recovered remarkably fast. Eventually, inflation moderated. But in what kind of financial shape would we be today had those unfavorable conditions persisted?
Risk Management
In the aerospace industry, engineers define risk as the probability of an outcome times the severity of its consequences. With that equation, aircraft manufacturers can take quantifiable steps to mitigate potential hazards.
Some potential hazards, like a house fire, are obvious. Perhaps even unwittingly, we apply the aforementioned risk calculus.
The probability of a house fire is low, but its consequences will likely be quite severe. So we purchase homeowners insurance at considerable cost to protect ourselves from the unlikely hazard.
Known Unknowns
Some hazards are difficult to foresee; what former defense secretary Donald Rumsfeld (in)famously referred to as known unknowns.
Engineers prepare for these, too, building systemic protections into to safety-critical systems. Such protections are designed to contain failures no matter the cause.
Wouldn’t it be nice to be able to protect our financial assets in a similar way?
Portfolio Insurance
Is it possible to achieve systemic protection for your nest egg, against hazards known and unknown? It turns out it is.
Suppose you have $1M invested entirely in the S&P 500 Index, via Vanguard’s S&P 500 ETF (VOO). You buy a put option on the entire position, at a strike price equal to its current value.
Now suppose a black swan swoops in and decimates the markets, reducing the value of your portfolio to $300K. You exercise the option, which obligates the party that sold you the option to buy your position in VOO for $1M. By purchasing a put option on your portfolio, you’ve effectively insured it against a catastrophic loss.
But for some differences in terminology, and the asset you are trying to protect, a portfolio put option is no different from a homeowners insurance policy. The portfolio put option manages systemic risk, and protects your portfolio in a way that, say, diversification alone, cannot.
The Bad News
Unfortunately, a one-year put option on your $1M position in VOO is prohibitively expensive—it would cost you something like $50K in today’s market. This renders it dead on arrival as a portfolio protection strategy.
Managing Risk
Can one achieve systemic portfolio protection at a more reasonable cost? A combination of strategies might allow us to at least approach that ideal.
Duration Risk
Maintaining a cash buffer to ride out market downturns is one such strategy.
I hold about one to two years of living expenses in Vanguard’s Federal Money Market Fund (VMFXX). Next to FDIC-insured savings accounts, money market mutual funds are about the safest place to park cash.
I can rely on VMFXX for a long period of market underperformance; crucially, without having to sell more volatile equity funds at a loss to generate cash.
I keep another two to three years of living expenses in Vanguard’s Total Bond Market ETF (BND). BND has an average duration of six years. Roughly speaking, this means that even if the price of BND goes down—say due to rising interest rates—that price drop will be offset by higher returns as the fund’s older bonds mature and get swapped out for new, higher-yielding ones.
Holding three to five years of cash/near-cash equivalents prevents me from having to sell depressed stock fund shares for all but the longest of market downturns.
Consolidation Risk
The opposite of consolidation is diversification. Like most investors, I diversify my investments across a range of asset classes and geographic regions to protect myself from consolidation risk.
I invest about 90% of my portfolio in high-quality mutual funds and ETFs. By high-quality, I mean equity funds that hold primarily the shares of well-established mid- to large-cap companies, and bond funds that hold mainly investment grade corporates and U.S. treasuries. All track broad indexes, and therefore charge minimal management fees.
As a hedge, I invest the remaining 10% of my portfolio in alternatives. Specifically, these consist of the SPDR Gold Shares ETF (GLD) and Bitcoin (BTC) (the latter I own directly).
A Defense of Alternatives
Notwithstanding the perfect storm that decimated nearly all financial assets in 2022, there are hazards I feel justify holding GLD and BTC; say a plunge in the value of the U.S. Dollar (USD).
Think it can’t happen here? The Spanish Dollar, Dutch Guilder and British Pound held global, reserve-currency status for more than a century each. Not unlike USD today, that status was thought to be unassailable by elites of the day.
Hedgers and Speculators
Some investors use risky assets to speculate. Speculators place large bets, sometimes more than they can afford to lose, on these in hopes of striking it rich. Others take a more measured approach; they place small bets on risky assets to hedge their larger, presumably safer, bets.
Adam Grossman, founder of Mayport Wealth Management and contributing writer to the Humble Dollar, is by all accounts a conservative investor. Yet he made a compelling pitch for hedging at last year’s Bogleheads conference.
To be clear, this is not financial advice. Owning GLD and BTC clears my high (perhaps paranoid) bar for financial resilience. It may be too high for yours. But remember the risk equation: if the probability is low, but the consequences high, then a hedge might be worth considering.
Longevity Risk
Just like a homeowners insurance policy, or a portfolio put option, an annuity can be thought of as a form of insurance. The hazard an annuity is designed to protect against is longevity; that is, the risk of outliving your savings.
In exchange for a lump-sum payment to an insurance company, an annuitant can expect to receive periodic payments—typically monthly—for the duration of their lifetime. If these payments are sufficient to cover the annuitant’s living expenses in perpetuity, the annuitant can breathe easily knowing they will never outlive their money.
Annuities come in many forms, each with pros and cons designed to suit the particular needs of the purchaser. Among these are fixed, variable, indexed, immediate and deferred annuities.
No matter the variant, annuities are not cheap. All are bogged down with complex caveats and exceptions. None comes without some degree of counterparty risk.
Related: Annuities Revisited: Downsides, Deal Killers, and Alternatives
Social Security, Anyone?
I’ve never quite understood the value proposition of annuities. All U.S. employees who pay into FICA or SECA (otherwise known as payroll taxes) are eligible for the best annuity money can buy (or rather that you’ve already paid for!).
As to counterparty risk, Social Security is backed by the U.S. government. Uninspiring though this may be to some, I trust the U.S. government to make good on its financial obligations a lot more than I do any private-sector insurance company.
Best of all, Social Security is indexed for inflation; a feature absent from all but the most expensive annuities.
Scam and Fraud Risk
Last December, the Cybersecurity and Infrastructure Security Agency (CISA) discovered hackers had infiltrated the networks of several U.S. telecom carriers, allowing the hackers to intercept unencrypted text messages transmitted on those networks.
Though not likely to be targets of these sophisticated hacks, average Americans are nevertheless vulnerable. Such a breach represents a massive hole in the SMS-based two-factor authentication (2FA) many of us rely on to secure online access to our bank, brokerage and/or retirement accounts.
This revelation prompted me to undertake a thorough review of the security settings on all my sensitive, online accounts, and take action to remediate shortcomings. Specifically, I switched to authenticator-based 2FA on all such accounts.
I played down authenticator-based 2FA in a post about cybersecurity I published last year, arguing that SMS-based 2FA is good enough. I have since changed my mind.
Related: Protecting Financial Assets from Fraud, Theft and Scams (Part 1)
Related: Protecting Financial Assets from Fraud, Theft and Scams (Part 2)
Make the Effort
I can’t stress enough the importance of securing your sensitive financial accounts—this is no less important a risk-management strategy than any of the others. This means using strong passwords (or passkeys, if available), authenticator-based 2FA, account lockdown features…basically, the best security features your online platform has to offer.
This will cost you some setup time up front, but not much. Once it’s done, you won’t have to think about it (you may even sleep better at night).
If you have trouble getting inspired, remember the risk equation: The cost of inaction could wipe you out.
Summing Up
Asset diversification alone is not sufficient to protect us from systemic financial shocks, or any single event that would cause damage to the totality of our finances. Instead, we need a multi-pronged approach.
I find it useful to adopt a more expansive definition of diversification; one that includes the strategy diversification I laid out in this post, or the institutional diversification I discussed in a previous post.
What other aspects of our lives might we diversify to protect our finances from hazards known and unknown? Share your thoughts below.
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[I’m David Champion. I retired from a career in software development in March 2019, just shy of my 53rd birthday. To position myself for 40+ years of worry-free retirement, I consumed all manner of early-retirement resources. Notable among these was CanIRetireYet?, whose newsletters I have received in my inbox every Monday morning for the last ten years. CanIRetireYet? is one of exactly two personal finance newsletters I subscribe to. Why? Because of the practical, no-nonsense advice I find here. I attribute my financial success in no small part to what I have learned from Darrow and Chris. In sharing some of my own observations on the early-retirement journey, I aim to maintain the high standard of value readers of CanIRetireYet? have come to expect.]
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