From Investment Products to Investment Solutions

Introduction

Modern investment products and services are broken.

They miss the mark in a couple vital ways that can have devastating impacts on your financial plan and retirement income.

Let’s take a look at those problems…

An outdated theory and poor “diversification”

Diversification is key.

However proper diversification is rarely achieved in modern financial planning.

Most of the tools available to advisors – and the investment advice they give – come largely from one place:

Modern Portfolio Theory (MPT)¹

MPT is an investment framework fathered in the 1950s by economist Harry Markowitz (so maybe it’s a not-so-modern portfolio theory).

Its goal is to explain the relationship between market risk (a.k.a. “systemic risk”) and asset returns – arguing that the ideal investment strategy depends on the market risk and return of each type of asset class, and the relationship between all asset classes.

A fancy way of saying (relative) risk vs (relative) reward.

And MPT provides investment rules that are still largely in use today… but why is that a problem?

It doesn’t exist in the real world.

Future returns and correlations – the two main inputs in MPT – aren’t actually observable in the real world.

No one’s psychic, so future returns are immediately off the table.

As for correlations between every asset class: let’s take a look at a graph correlating the S&P 500 (a normal proxy for the equity class) and the U.S. 10-Year Treasury Bond Index (a normal proxy for the fixed income class), over the last ~30 years.

The closer the graph gets to 1.0, the more correlated the indices are. The closer to -1.0, the more entirely uncorrelated they are.

Figure 1 Historical correlations look like a random generator of numbers between -1 and 1.
Sources: Intrinio (market data) and Lifeworks (calculations).

It looks like a random number generator picking between -1.0 and 1.0.

So random, in fact, that it’s hard to imagine basing an entire investment theory around any such “strong” correlation. Especially the investment theory driving most financial advice today…

It gets risk all wrong

MPT uses the volatility of an asset as the only measure for risk.

You can think of volatility as how much an asset deviates from its average return over a certain period – the higher the number, the “riskier” the position.

Let’s say you hear someone mention that “ABC Corp. has a 20% volatility.”

All that means is, typically, the returns from ABC Corp.’s equity will deviate by about 20% in a given year from its average2. So if the average stock price were $100, you could expect it to flux between roughly $80 and $120 over a year.

Good information to have, but it doesn’t tell us everything we need to know about the actual risk of ABC Corp.

Remember collateralized debt obligations (CDOs) that underpinned the Great Financial Crisis back in 2008?

Leading up to the crash, their value had consistently increased, so their actual and average returns were equally high, meaning they had very low “volatility”.

From Modern Portfolio Theory’s point of view, they weren’t risky at all.

… until they sent the U.S. and the broader global economy into a years-long tailspin.

So here’s the big takeaway: There are many types of risk – not just volatility – and they all should be taken into account when building your portfolio. Anyone using a single measure of risk should at best, be considered disingenuous, and at worst, a charlatan.

Personal goals take a back seat

At the end of the day, your financial plan only has one purpose:

To achieve your specific goals.

Unfortunately, traditional investment managers and their products ignore this purpose and instead focus on matching you to the right one-size-fits-all portfolio and trying to beat an arbitrary investment target (like “the market”).

The limits of 60-40 types of portfolios (60% invested in the S&P 500 Index, 40% in the U.S. 10-Year Treasury Bond Index), also called “policy portfolios”, were talked about as early as 2003 by Peter Bernstein³.

He argued that any need to react to market changes that affect investors’ chances of achieving their goals undermines the relevance of any portfolio that would be held constant over time.

In other words, the need to react to market changes makes a perpetual 60-40 portfolio… sub-optimal.

And the evidence has piled up since then.

Compelling research has been compiled by prominent academics, like Robert C. Merton⁴ and Saad Badaoui, backing up Bernstein’s claim.

Enough for us to argue that a dagger should – finally – be put through the “policy portfolio”.

So it didn’t come as a surprise when providers of traditional policy and target-date portfolios found themselves in the crosshairs of massive industry change.

But their disruptors – so-called robo-advisors – have missed the mark as well.

Robos explicitly market the pursuit of investors’ goals (which we love), but they fail to recognize the relevant risk for investors, and just like traditional investment products, they end up offering policy and target-date portfolios.

And it’s not all bad…

Their efforts to lower trading costs, automatically rebalance portfolios, and gamify investments with user-friendly apps are all great advancements from an investor’s point of view.

But for all the good reasons there were to disrupt the industry, robo-advisors still missed the most important one:

Creating solutions that recognize the uniqueness of each investor and their goals.

Robo-advisors still end up grouping everyone into very large groups according to their type of goal (major purchase, retirement, education, general investing, etc.).

Then everyone within the group is assigned the same stock-to-bond distribution.

You can barely call it customized.

And you certainly can’t call it calibrated.

How can Lifeworks do better?

We start by expanding the Modern Portfolio Theory understanding of risk to include market regime risk and personal goals.

Then we change the traditional goal of an investment portfolio:

The core objective should be to maximize the probability of achieving the investor’s consumption and legacy goals.

From this angle, the investment portfolio is guided by the financial plan.

It is unique to the investor and it is liability-driven.

This means it ought to be dynamic, flexible, and liquid – attributes we’ll explain in a bit more detail below.

It’s a solution.

Its objective isn’t to…

Amass the biggest pot of gold possible;
Take the least amount of risk to best preserve capital;
Find a compromise between these two extremes by gathering a meaningless “risk score” from a questionnaire you take once, creating a static portfolio;
Be a product.

We consider product-based practices to be obsolete.

Following in the footsteps of some of the most recognized finance academics, we have long advocated for financial innovation, and have built the technology to propel the new investment paradigm.

The shift from investment products to investment solutions underpins the methodology followed by your financial advisor and the Lifeworks investment team, working hand-in-hand to help you achieve your goals.

Liability-driven vs. Behavior-based

Our investment process is liability-driven (with the main liability being the cash flow you need to live the life and leave the legacy you want).

Portfolio building doesn’t even start until you’ve established the first version of your financial plan with your advisor.

This is for two reasons:

The portfolio’s core objective is to accomplish the plan… which it can’t do unless you’ve built the plan.
We aren’t brokers. We aren’t selling commission-based products. We are simply strategists providing an investment solution.

Expected revenues (assets) and consumption and legacy goals (liabilities) are projected on an annual basis.

The amount, timing, and likelihood of your future cash flows – both in and out – are the main drivers of portfolio allocation.

They define the composition and risk loading required of the portfolio as you accumulate for retirement (or whatever your goal is), and the replacement income strategy for once you’ve retired.

Target-date Funds

Our system improves on the traditional approach of target-date funds (funds that shift allocations to more conservative assets as you get closer to retirement).

We have nothing against target-date funds – we also recognize that the amount of risk in your portfolio should depend on the timing of your liabilities, but here’s the major difference:

Target-date funds use a single input: The year you expect to retire
We use all your liabilities: Taking into account the size and timing of all your needs and cash flows as you approach retirement

This lets us define three risk buckets, or “tranches”, where we map the risk in your portfolio to future income needs (see Figure 2 below).

Figure 2 Tranches replacing risk assessment questionnaires and alleviating the portfolio construction problem.

Risk tolerance / surveys

We’ve also improved on the traditional risk-tolerance or risk-survey approach many advisory firms use.

They’re a norm in the financial advice industry; surveys that vary in content and length, but have one main purpose: Consolidating your unique situation into a single variable (your score) that “measures” how much risk your portfolio should assume.

While there are more than a few reasons these surveys fall short (you can read them all here), our main objection is that your retirement, your finances, and your legacy require more nuance than a single score could possibly tell.

Instead, Lifeworks’ RIS allows for a customized, dynamic, and flexible risk management strategy, unique to each investor. We’ll cover how in the next section:

Unique, dynamic, and flexible

Because every client’s cash flows and goals are unique, so is their optimal risk-loading, and their portfolio as determined by Lifeworks’ RIS. Figure 3 shows an example of optimal allocation between tranches (buckets) for a Lifeworks client, based on their individual situation.

Figure 3 Customizing tranches according to the client’s financial projections

But this isn’t static.

As your life changes, your financial plan changes, your risk tolerance changes, and the allocation within each bucket changes. Allocation is dynamic – just like life.

Our portfolios, described in more detail below, are created with the most liquid and flexible assets to allow for the necessary changes that match your financial plan.

Trache 1 (“T1”) represents your projected cash flow needs for the next 3 years:

This is your safety net for when markets – or the entire economy – get shaky.
We use 3 years because that’s the longest recession in the U.S. since the Great Depression.⁵
To preserve purchasing power, we place a particular focus on inflation-protected safe instruments.
Instruments used include (but aren’t limited to):
- Cash
- Money market ETFs
- U.S. Treasuries
- CDs

Tranche 2 (“T2”) represents the projected net cash flow needs for years 4 – 10:

The main goal is to generate income while pursuing capital appreciation opportunities.
Our Balanced Income Portfolio invests in high-quality and low-volatility dividend-paying stocks, with a strategic layer of investment-grade bonds.
This results in a stable, income-producing portfolio.

Tranche 3 (“T3”) represents the projected net cash flow needs for year 11 and beyond:

Focused on long-term growth and capital appreciation
Our Diversified Premia strategy (“DP”) is at the cutting edge of investment innovation and strategy:
- It combines the benefits of smart beta (“Diversified”) and factor investing (“Premia”) to deliver superior risk-adjusted returns.
- Our team of quantitative investment strategists (“Quants”) leverages big data, rigorous scientific and mathematical models, and dynamic (there’s that word again) calibration to incorporate the most relevant economic and financial market info into the portfolio.
- Diversified Premia can be broken down into its two pillars:
  - Opportunity focuses on growth factors like innovation and momentum. The strategy offers exposure to the 50 stocks with the highest trading momentum and the greatest potential to disrupt industries.
  - Quality focuses on a set of robust value vectors like high profitability, high payout, and low volatility. It invests in the 50 equities that have established the most durable operational edge over competitors, have the highest profit margins, and take the most shareholder-friendly corporate actions.

Finally, the Tactical Portfolio provides exposure to alternative asset classes that…

Are stores of value and represent safe havens during market sell-offs (commodities like gold)
Have the potential to become widely accepted as stores of value (digital coins like Bitcoin)
Mediums of exchange (digital coins like Ethereum)
Have singular return profiles like real estate (diversified and liquid investments only)

Lifeworks’ Tactical allocations are customized to each client to:

Optimize the efficiency of their portfolio
Increase the probability that they reach their personal wealth goals

Footnotes

To be more precise, this statement and the conceptual definition that precedes describe what the “mean” deviation is. “Standard” deviation used by MPT is a slightly different animal, a more blurry one conceptually speaking and also a more complex one as far as calculations are concerned. However, it exhibits convenient mathematical properties, hence its wide applications. We won’t delve into technicalities here but the relevant Wikipedia article won’t disappoint its reader.
Markowitz, H., “Portfolio Selection”. The Journal of Finance, Vol. 7, No. 1., pp. 77-91, March 1952.
Bernstein, Peter. “Are Policy Portfolios Obsolete?” Economics and Portfolio Strategy, March 2003.
Merton, Robert C. “The Crisis in Retirement Planning.” Harvard Business Review, July 2014.
https://www.statista.com/statistics/1317029/us-recession-lengths-historical/