How to De-Risk Our Investment Models

At Model Investing we frequently receive two questions from investors:

1. Is your investment approach conservative, moderate, or aggressive?
2. If I’m close to, or in retirement, how do I adjust your recommendations to
   accommodate my lower risk appetite?

These are excellent questions, and we’ll address each one below. As you’ll see, the answers
to both of these questions are related, and require a basic understanding of portfolio
management to answer appropriately.

Let’s begin by addressing the first question. In order to do this, we need to understand
exactly what these terms (conservative, moderate and aggressive) really mean.

Conservative, Moderate or Aggressive?

In the context of investing, these terms refer to how much risk an investor is willing to
take in pursuit of returns. A conservative investor tends to be risk averse, preferring a
more stable portfolio that does not fluctuate heavily in value. On the other hand, an
aggressive investor is willing to take on substantial risk in exchange for the possibility
of high returns. Moderate investors lie somewhere in the middle of this spectrum.

But what exactly is it that determines this risk? What makes one investment “aggressive”
while another is “conservative”?

The answer lies in how much volatility a particular investment, or
investment strategy, experiences. For example, stocks tend to fluctuate much more in value
than bonds do, and as a result, are considered riskier. Keep in mind that this is not
necessarily a bad thing, as more fluctuation in value means more potential growth as well.

Thus, when it comes to one’s portfolio, the term aggressive has come to represent a high
allocation allocation to stocks, while conservative represents a high allocation to bonds or
cash.

So where do we fit in?

Our investment models shift between these asset classes based on the economic cycle, and as a
result have a level of volatility consistent with a moderate portfolio.

To put this in perspective, the volatility of a pure stock portfolio over the last two
decades ranges from about 18-20%. At the same time, the volatility of a portfolio of bonds
has been around 3%. Our investment models, by comparison, have seen volatility in the 9-12%
range.

What’s interesting, however, is that while our investment models have experienced as much
risk as a moderate (sometimes called blended) portfolio, they have provided returns that
exceed that of an aggressive, 100% stock portfolio. In some cases the
outperformance has been quite dramatic, outpacing the S&P 500 by 2.7 – 3.8% per year.
(See our investment model overview pages for additional details.)

Accommodating a Lower Risk Appetite

Now that you understand you should expect a moderate level of risk when following our
investment models, let’s discuss how you can adjust that risk according to your personal
preferences.

Based on our discussion above, you might be tempted to think that if you want to take less
risk, you should simply adjust our recommendations to have more of your portfolio in bonds
and less in stocks. Please do not do this.

Our investment models make their allocation decisions based on the state of the economy and
financial markets. Their goal is to deploy capital in the most effective manner possible,
and this is often achieved by maintaining a certain ratio of stocks to bonds. If you mess
with the recommended allocations too much, you could not only increase the expected
risk profile of your portfolio, but also harm its ability to generate returns.

The better way to approach this is by adjusting how much of your total portfolio you expose
to risk, or in this case, how much of your portfolio you follow our investment models with.

For example, if you were planning on following our investment models with 100% of your
account, but want to take less risk, then consider following our models with only 90% of
your portfolio and leaving the remaining 10% in a risk-free money market account, or a
stable value fund. If that’s too risky for you, then follow our models with 80% of your
portfolio and keep 20% in a stable value fund. Make sense?

Using this method to de-risk your portfolio accomplishes two objectives: It truly does reduce
your overall portfolio risk (whereas changing allocations can actually increase that risk
depending on where we are in the economic cycle), and it also ensures that you remain
positioned correctly to capture the growth that our investment models offer.

In determining how much of your account to follow our investment models with, you may find it
helpful to review our article: How to Manage Risk as You Age. In this article we
provide a general framework for determining how much risk you should take over time,
including how to account for a variety of personal factors.

Additional Considerations

Risk control is always a key consideration when it comes to investing, and one that often
feels very personal. But counterintuitively, the amount of risk you should take with your
portfolio is really not that personal of a decision at all. That’s because we’re all faced
with the same requirement in life: accumulating enough assets to fund our retirement years.

If you don’t take the necessary risks with your investments, your portfolio will fail to grow
at an adequate rate, and you won’t achieve your retirement objectives. The fact that we’re
all living longer these days makes this consideration all the more pertinent.

Finally, there is one particular commonality that we’ve noticed among some investors,
particularly younger investors, and that is an aversion to the stock market. We know that
being invested in stocks can be a harrowing experience at times, but the stock market has
been and still remains the greatest single wealth generator in history.

Not taking full advantage of the long-term growth in the stock market is a huge mistake, and
unfortunately one that is committed all too often. If it makes you feel better, remember
that the stock market is biased to the upside, and over the long-run always moves higher.

Hopefully this article has given you some perspective on the amount of risk inherent in our
investment models, and how to reduce that risk if you so desire. But as always, if you have
any questions at all, please don’t hesitate to ask.