Budgeting doesn’t get the respect it deserves.
A common topic of conversation I have during the initial stages of a consulting relationship is the one centered on risk. The word itself has become the marketing banner for many institutions; risk monitoring and control is the name of the game.
While I’m not belittling the issue, I am nevertheless doubtful that the emphasis has gone a bit too far and it has been misplaced.
In our industry we mostly associate risk with the price volatility of an investment or a portfolio, often measured with quantum-physical precision of 2+ decimals. I know I’m simplifying things when I say this, but the reality is that almost all of the time spent with clients discussing risk is centered on reconciling how much the investor can ‘bear’ versus how much an investment changes in value over a certain period of time.
This method of looking at risk is somewhat deceptive. In fact, it is almost backward. Risk measured as the volatility that can be ‘borne’ by the investor can lead to unhelpful conclusions when the investment horizon is very long and/or when the objectives involve real – inflation-adjusted – variables.
If we assume an investment approach that encompasses sufficient diversification and reasonable return expectations, there are mainly two risks to account for:
a. The risk of premature withdrawals. I’ve touched on the subject once before in this post. Size and timing of portfolio withdrawals are crucial elements in an investment program. If your investment time horizon is infinite, with no withdrawals, then the asset allocation is simple – 100% equities. Equally simple is the solution in the case you need all of the money tomorrow – 100% cash, preferably in the bank and not under the mattress. Anything in between is also manageable by calibrating the mix and including fixed income securities. By framing the question around the investor’s cash flow needs, we essentially define the maximum volatility the assets can sustain without endangering the investment objectives. In investment terminology, we immunize a portfolio.
b. The risk of inflation. Portfolio value and cash flows have to grow in time at least as much as the rate of inflation. If not, by definition they will reach a point where they fail to satisfy the objectives. Even if today the risk appears so remote that we are all focused on its opposite sibling, inflation in general receives scant attention in most investment programs developed for individual investors. But it is such an important and potentially destructive variable that I often wonder why we don’t view all investment analyses and data (ex ante and ex post) in real terms. A ‘riskless’ investment in cash won’t do in these circumstances.
If you have followed the reasoning so far, in its simplicity and maybe even naïveté, and you associate with the underlying problems, you couldn’t be blamed for arriving at the logical conclusion that the most important action to take in defining risk for your portfolio is a proper budgeting exercise.
With simple budgeting you have the tool to help you define an appropriate portfolio allocation and even determine what inflation rate you can ‘afford’ to face.
Roberto Plaja, May 30, 2019