Many global markets have slipped into correction or near-correction territory. As I write this, the TSX Composite Index has dropped 10.4% from its early September high. While stock market volatility isn’t much fun for private investors, those that have planned for it need not fret. A properly specified portfolio that has taken this inevitable risk into account can weather and capitalize on the “bumps” along the way. One way to insulate your portfolio from market declines is to make sure you have properly segregated your short- and medium-term cash needs from your long-term investments.
Private investors define risk in a much different way than investment analysts and portfolio managers. To most industry types, risk is frequently expressed as the degree to which a stock moves up or down in relation to the average stock, or as the expected movement in a bond’s price for a given increase or decrease in interest rates. This, however, is often of little relevance to most private investors who define risk as losing money or running out of money in retirement. As it turns out, private investors think more like pension plans, who share many of the same concerns.
Private investors save today with the goal of meeting their objectives in the future. Similarly, pension plans have savings today (assets in the form of employee plan contributions) and future obligations (expenses that must be paid out to retirees). Risk, to a pension plan, is not having the required assets in the future to meet those promised obligations. Essentially, both are concerned with not having enough down the road in an uncertain world.
Professionally-managed pension funds have a few good ideas about how to ensure they can meet their future obligations – the most important of which is a discipline called Asset Liability Matching, or ALM. The concept is quite simple: if you have a known liability in the future (a pension payment to a retired plan member), you should buy an investment today that matures just before the obligation is due, at a value equivalent to the payment amount. For example, if the plan has an obligation to pay $100 to a plan member in 10 years, the manager might buy a zero-coupon bond today for $74 that matures in 10 years at $100. With an ALM strategy, the pension plan does not have to worry about running out of money since it has effectively matched a current asset with a future liability.
Private investors will have a difficult time matching assets and liabilities at the same level of detail as a well-managed pension plan, but the concept is still important to follow. They can simplify their investment approach by lumping their future objectives into three buckets – short term, medium term, long term – and then matching their savings to each of these buckets. Short-term cash flow needs should be invested in near-cash securities or a money market fund. Medium-term savings should be invested in a bond fund or individual bonds with maturity dates that are matched to the date those savings will be needed. Long-term assets should be invested in equity or equity-like securities with the objective of achieving a higher return without subjecting the investor to a high degree of risk associated with running out of money.
An ALM strategy can help take the emotion out of investment decision-making, providing the peace of mind that investors have a plan in place to help them meet their goals and objectives – whether these goals are 10 months or 10 years into the future.