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In Good Times and in Bad

Peter Mladina reveals how portfolio managers utilize specific asset classes to mitigate portfolio risk.

As appeared in Wealth magazine

In Good Times and in Bad

Peter Mladina reveals how portfolio managers utilize specific asset classes to mitigate portfolio risk.

Wealth: What are risk control assets, and what role should they play in a client’s wealth management strategy?

Peter Mladina: We define risk control assets as investment-grade bonds, inflation-protected bonds and cash investments that historically helped stabilize an overall investment portfolio, but can also help fund high-priority, nearer-term financial goals such as lifestyle spending. For near- to intermediate-term goals with an inflation component, such as spending needs in the next two to four years, some shorter-maturity, Treasury inflation-protected bonds also can play a role.

Consider a retired couple using their investment portfolio to fund their daily living needs when the capital markets hit a period of volatility. Under a traditional portfolio management approach, the couple may be forced to liquidate a portion of their assets at distressed values to fund living needs. If we look back to the Great Depression, the 1970s or even our more recent experience of 2008, we clearly see examples of this. However, maintaining risk control assets in a portfolio can help clients meet their spending needs even in periods of market turmoil by allowing time for their other investments to recover.

This also would apply to investors who depend on their human capital or earnings power to fund their lifestyle goals. Significant distress in the economy or a major recession can reduce or eliminate an individual’s earned income. Risk control assets in the portfolio can help meet lifestyle needs for a period of time until a client can recreate his or her human capital, for example, by finding another job.

Wealth: How can clients determine an appropriate amount of risk control assets within their portfolio?

Mladina: Fundamentally, all of a client’s assets could serve the purpose of potentially funding his or her financial goals. The right amount of risk control assets can be based on a client’s risk preference for how many years of lifestyle spending he or she wants to protect.

One way to help clients answer this question is to consider historic durations of financial distress:

  • It took equities about 16 years to recover from the 1929 Stock Market Crash and Great Depression. Would 15 to 20 years of lifestyle expenses held in risk control assets be worthwhile? Clearly, this is an expensive option for most people, but it may be appropriate for those risk-averse investors who can afford it.
  • In the 1970s, after adjusting for high inflation, it took about 12 years for equity markets to fully recover. Recent history, which includes the tech bubble peak in 2000 and the 2008 recession, offers another 12-year interval. Is that time frame appropriate?
  • When we look at the history of real equity versus quality fixed-income returns from 1926 to 2012, we find that a large component of equity risk relative to fixed income risk is reduced within seven to eight years. Is that the right time frame?
  • Different historical and simulated stress tests performed on the risk control and risky assets separately can provide more granular guidance on the number of years of consumption protection held in risk control assets.

It’s important to remember, however, that the more an investor uses risk control assets to mitigate capital market distress, the greater percentage of liquid net worth is needed in the overall portfolio. So it’s a tradeoff between risk preference (how many years of lifestyle a client wants to protect) and risk requirement (how many years a client can actually protect based on the size of the portfolio).

Wealth: How do risk control assets help clients stay the course during periods of market distress?

Mladina: When clients use risk control assets to fund high-priority goals like lifestyle spending, they have the luxury of taking a longer-term view of all their assets. This often gives the client the ability to ignore short-term volatility and the occasional bouts of distress inherent in the financial markets. The ability to remain calm, and not be forced to sell assets at distressed prices, may give a client a longer-term perspective on how best to achieve his or her goals.

Ultimately, if successful outcomes are defined by achieving financial goals over the course of a lifetime, the safest place to be is in a strategic portfolio that is aligned with those goals.

 

Wealth: How does all of this tie to Northern Trust’s Life Driven Wealth Management approach?

Mladina: From a holistic Life Driven Wealth Management perspective, it’s all about helping clients meet their life goals. Investors typically have a series of financial goals that they desire to fund. Our objective is to align their goals with their investment portfolio. From this perspective, goals directly drive investment strategy. Rather than measure a client’s success by how they performed against a random benchmark, we measure success by what actually counts for clients – whether they efficiently fund their goals over time.


For more information on Life Driven Wealth Management, visit northerntrust.com/lifegoals.

Peter Mladina is the director of portfolio research for Northern Trust.