Can extra savings mean you can strategically take LESS risk ?

If your savings are actually growing faster enough to achieve your long term objectives, should you be taking on significant stock market risk just get “better” returns ? With return of volatility in Jan 2016, it is painfully obvious that portfolios with a sizable asset allocation to stock market risk can significantly reduce the predictability of returns.

For example, currently our net worth grows about 7% a year from saving earnings (assuming zero investment growth), and I’m not sure we need to take on tons of market risk to get where we want to go. We can also predict our net worth worth next year typically within 4% or 5%. For example, worse case if the stock market went down say 50%, then currently we might lose say only 15% of our net worth, but then we’d be able to buy a cheaper house with all the cash. If you cant sleep at night due to the risk, then you’re too heavily invested – we are aiming not to be in that position.
Our finance jobs directly benefit from large trading firms taking equity risk premium – so arguably our savings are just equity profit, provided by people at our employer who are much better at taking risk than we are. I know that “in theory on average in the long run” you should make more money from a Personal Capital long equity style strategy, however we can’t handle the 10% monthly swings along the way (e.g. if we were allocated as anything like close to the “recommended” stock exposure, that would have been this month’s move).

The allocation we have to an all stock “aggressive” strategy is only about 8% of our entire net worth allocation, so we are comfortable with the current risk. We deliberately picked a more risky aggressive strategy for this reason. Our asset allocation manages risk by having bigger than normal cash positions, and taking potentially larger than normal risks with a smaller amount of our money. We have various other strategies e.g. peer to peer lending, that make about 7% . We are not comfortable being all invested in one strategy, no matter what the “high risk or low risk” split. Just moving the dial between 100% stocks (high risk) and 60% stocks / 40% bonds (“low risk”) doesnt help in market crashes because everything tends to have to be tightly correlated when you need it the least. The stock strategy is based on traditional modern portfolio theory, and doesn’t really manage correlations very well. Most of the time its FINE, but it is the periodic fat tails (e.g. down 50% in 2009, and down 10% this month) where the typical correlations (e.g. bonds up/stock down) stop working. In a crash asset prices tend to get into a feedback loop and being “diversified” in say European, Asian or US equity actually ends up being the same trade. Also diversification does not significantly reduce risk over about 30 holdings, so being in too many holdings doesn’t help as much as people think.

Another important idea to reduce market risk, is strategy diversification in the market. In April 2015 I removed about 1/3 of our Personal Capital allocation into my own IRA where I’ve been trading limited risk reward long/short ETF options, often taking advantage of selling high volatility premium. Admittedly sadly down about 2% so far in 2016, however significantly less correlated to the market sell off than we have seen recently, and it is recoverable and not directly correlated to “long only” market strategies. This has still got “market risk” in it, but has diverified across strategies to be selling inflated option premimums, versus just being net long a “bunch of stocks” – it will be affected by market moves but because it is long/short or sometimes delta neutral it can benefit from down or sideways market action as well.

If you are very conservative with 90% of your money, you can take calculated out sized risks with the remaining 10%. This would be where you would apply your 10 ideas to make 10% or more returns strategies, effectively allocating 1% of your net worth to each idea. Many ideas would fail, but for example on a $1 million account, investing $10k in a single idea could be massively profitable it works, but if it totally failed it would not impact the overall portfolio returns. Also if you are constantly saving cash (either your job or other income sources) to replace the $10k put into the idea then arguably the risk is only time to replace the failed investment (given that it such a relatively small overall amount). Arguably as well you would learn a lot in the process, and by being actively involved in your investments you learn what did and did not work, without having the stress and risk of losing a significant amount of your net worth.

In summary we would only use a standard “long stock market” approach as one strategy of many, and we understand that we are giving up on any excess potential return, in exchange for piece of mind. Our overall asset allocation, is therefore never going to be close to a traditional asset allocation. We don’t need the best possible risk/reward ratio for all of our money, we just need to aim to keep on track to achieve our long term objectives – and that might mean its totally OK to take on significantly less traditional long only equity stock market risk.

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