Step 1 of Retirement Success Plan: Investment and Portfolio Analysis

Troy Sharpe: I’m giving the choice of two investments, investment A and investment B. Both of them return 10% over the previous year, which one would you rather have been invested?

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Troy: Oftentimes, when I ask this question to a prospective client, I’ll get the response, “Troy, it doesn’t matter. They both returned 10%. Give me A or B,” but when it comes to retirement planning, and this is why step one of the RSP is so important, the allocation meeting, it’s not about the return necessarily, it’s about how much risk did we have to take to get that return. Investment A and B both had a 10% return, but this is just one outcome in an infinite set of possible outcomes.

An Investment Return Scenario: Which One Would You Choose?

Remember, these are two distinct investments with different characteristics, possibly different purposes. Even though they return the same, the question is, how much risk did we take to earn this return? Are we being compensated enough from a reward standpoint based on the risk that we’re taking? With a high degree of statistical confidence, we could analyze and say investment A had a likely downside scenario of somewhere between 5% to 15%. If a different set of outcomes or circumstances occurred, that’s the risk profile. Investment B had a possible downside of -20% to -40%.

Now, with that new bit of information, which investment would you choose, investment A or investment B? All individual investments or combination of investments could be plotted somewhere along this chart. This is what we call the efficient frontier. Over here we have the return, the expected return, and over here we have the risk that we’re taking. Ideally, we have investments that are more to the left, which represents lower risk, and higher up the Y axis, which represents higher return.

If you own five different stocks, that portfolio in and of itself could be plotted somewhere on this graph. If you have one security, let’s say you’re fully invested in your company stock, you could plot it right here on this graph. Now, if you have 20 or 30 or 50 different mutual funds or ETFs, or individual stocks, once again, that set of investments can be plotted somewhere on this graph.

When we plot investment A and investment B on the graph here, we can clearly see that they have a similar return profile, but investment A has less risk. This makes it easier to identify as an investment that we would rather place our dollars. Now, down here I have investment C. It could be a portfolio of stocks, this could be maybe if you have a lot of money invested in your company stock, but we clearly see that we’re taking more risk without being rewarded for that risk that we’re taking.

Another way to think about this is, think of your skills and the capability that you have in your current job or in your former job if you’re retired, would you take a salary that was much, much, much lower than market in order to do that same job with those same responsibilities? No, you probably would not, I know you would not. That’s what we’re doing here with investment C, essentially, we are taking risks or taking on responsibilities in that example while not being compensated for it.

How Much Risk Are You Willing To Take?

Okay, think of these letters, investment A, investment B, and investment C, this was the one we wanted to be in, this is the one that we took a little bit more risk for the same return, and over here we just don’t want to be in. I want to liken this to GPA, grade point average, because we’re all pretty familiar with that, either you from your schooling experience, you have kids or grandkids. In “A” investment or set of investments, I put a in air quotes here, that’s the GPA. What we want to do with your portfolio in retirement is increase its GPA. We want to reduce risk and increase expected return.

Now that you have a good understanding of risk and return and how every set of investments can be placed somewhere on that graph, it’s now important to tie that into retirement planning. The allocation determines how much income you can take, how much money will be left later in life. It determines how much tax you’ll pay in retirement, it can also impact your healthcare strategy or long-term care strategy, and it definitely impacts your overall estate plan. Those are the five steps of the RSP. This is why the allocation is so critical. It’s step one, because it impacts everything else.

What We Do During Your First Visit

When you reach out to us for the first time, all we do on that first visit is get to understand who you are and what’s important to you. We’re going to gather some of the objective data, of course, understand what your vision is for retirement, your goals, but the objective data is the current portfolio, the financial statements, the tax information, how much we want to spend in retirement.

In between that first and the second visit, we’re going to go through an analysis to see where your portfolio falls on that spectrum. In order to understand if there’s congruence between your willingness to take risk for the expected return that your portfolio can provide and where you currently are, we first have to identify what is that willingness that you have to take on risk. We have to first understand your willingness to take risk.

This is a pretty simple questionnaire here, simply saying, “Over the next six months, you’re comfortable risking this in order to make this potential return. Now, this is what we call a symmetrical risk return profile. We’re essentially risking $1 to earn $1, but really what we’re trying to identify here is what is your comfort zone on the downside, because what we’re going to try to do is create a portfolio that has an asymmetrical risk return profile. Less risk to achieve more potential return.

Are you comfortable losing 7% over the next six months in a recession or are you fine to let it stay invested and you believe long term capital markets are going to do just fine, so you’re more comfortable in the short term, possibly a 13% loss? There’s no right or wrong answer here, but everyone’s personal willingness to take risk is different. We have to identify that because if you have a portfolio that has too much risk, that is the one thing that will absolutely be certain to blow up a long-term retirement plan.

Our Plan for Market Volatility

If the market goes down, you call us up panicking and say, “Troy, I need to get out of the market. I can’t take it anymore.” You most likely won’t be in there for the rebound. All the planning that we’ve done up to that point can be significantly impacted because we were expecting the risk profile based on the conversations that we had to be structured properly. If it’s not and the markets go down, then we get out, all of a sudden everything is completely messed up. This is why your risk willingness is such an important concept, because if we’re putting a plan together, we need to know that you’re going to stick with it because markets will go down.

One other thing to point out here, I like to focus on the dollar amount because percentages can be deceiving. I had a client a long time ago, or a prospective client come in and say, “Troy, I’m comfortable losing about 10%.” He had $2 million. I said, “Okay, if the market goes down and you lose $200,000, you’re okay with that?” He said, “No, I’d fire you instantly.” There was a disconnect between the 10% and the $200,000. I like to talk about risk in terms of dollars because percentages seem– they don’t really drill down into our willingness to take risk. Whereas if we focus on the dollar amount, that hits home.

This would be coming back on a second visit, and we’re looking at your actual portfolio and this is very similar to what we see. Someone maybe told us that they’re comfortable, let’s say, with about 50% stock. When we do the analysis, what we often find is that there’s more risk inside the portfolio, but on top of there being more risk, oftentimes it’s not the most efficiently structured. We see down here we actually have, bringing the GPA back, a 3.1. This means that it’s not the most efficient from a risk-adjusted return standpoint, means we’re not where we want to be on that graph. An annual range, 3.42%.

For taking this much risk, we don’t want to be rewarded with an annual range midpoint here of only 3.42% over the next six months. Now, we also see with the potential risk and reward over the next six months, there’s a 95% probability that this portfolio to the downside couldn’t lose 16% over a six-month period, and the upside is plus 19%. These are very, very wide guardrails. If we extrapolate that out over the course of one year, we have a negative 32% and a plus 38%. Most of our clients aren’t comfortable losing potentially 38% in a single year.

Crafting Your Portfolio With Your Desired GPA

For this level of risk, based on the questionnaire that we asked earlier, and they come in around a 50 risk score, this is not only too much risk inside the portfolio, but it’s really poorly constructed from an analytical standpoint and the guardrails are far too wide. We’re not being compensated for the risk that we’re taking, and that’s what this GPA right here is telling us. That’s the analysis that we go through between the first and the second visit, and that’s often what we see. It’s not efficiently structured, the portfolio, possibly too much risk and oftentimes that GPA is a lower number, meaning we’re not being compensated with enough expected return for the risk that we’re taking.

In between that first and the second visit, that’s what our team is doing looking at your particular situation. Now, once you become a client and we go through that allocation visit, this is step one of the RSP, what we’re trying to do is to create a proposed portfolio that brings, first and foremost, the risk number in line with that questionnaire that we asked you before. We’re also trying to create some asymmetry in regards to the risk that we’re taking and the expected return of the set of investments that we’ve put together.

Now what we’ve done is we’ve lowered the overall risk score of the portfolio to be more in line with the questions that we were asking in regards to that slider that we had on the screen. If you are not comfortable with potentially losing 19% in a six-month period, we need to bring the risk score down in the portfolio. That’s the first thing that we’re trying to do.

The second thing is we’re trying to create asymmetry here. You see this, we’re risking nine for the potential of 15. This is over a six-month period. We extrapolate that out over 12 months, it’s minus 18 for plus 30. That’s asymmetry when it comes to the risk return profile. Additionally, we’ve increased the GPA of the portfolio. The maximum according to the software is a 4.3. This means we’re being properly compensated for the risk that we’re taking. The expected return is the proper compensation for that risk.

Now, anything can happen. Markets can go up or down, but what we’ve done is we’ve created an efficient portfolio that when markets are up or when markets are down, our potential returns are in line with our willingness to take risk. Also, when we’ve tied this into your income plan, tax plan and the rest of the RSP, it’s all creating a much more congruent financial planning experience. Also, the expense ratio over here. I don’t know if you’ve noticed before, but we had an expense ratio, and the mutual funds, and that current portfolio, and the proposed portfolio, we’ve eliminated those fees.

In summary here, during the first visit, we get to know where your willingness to take risk is. Between the first and the second visit, we’re going through and doing an analysis of your current portfolio, identifying the risk score, see if there’s any disconnect between your willingness to take risk and the actual risk inside your portfolio, but then also looking at the potential return; what is the GPA, what is the expected return, what is the symmetry between these two once you become a client, and we go through the allocation meeting.

Here’s where we look at the proposed portfolio, where we get the risk number of the portfolio in alignment with your willingness to take risk, try to increase the asymmetry between the risk and the potential return, increase the GPA of the portfolio, and increase the expected return.

Why The Allocation Visit Is The Most Important First Step

All of this is a shortened version of what the actual allocation visit looks like, but it hopefully conveys how important this step is because it not only determines the amount of risk or the potential downside you could see to your values in retirement, it also, of course, contributes to the potential return, which then dominoes into your income for retirement, the taxes, the healthcare plan and also the estate strategy. Step one, allocation, extremely critical when it comes to the retirement success plan. This is why we do it first.

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