Should You Build a Portfolio of Compensated Risk Premiums?

Andrew Miller, a partner at Creative Planning, joins Morningstar’s The Long View podcast to discuss financial planning, investment management, and ways to protect your portfolio from inflation.

Here are a few excerpts on inflation-protective qualities, risk capacity, and portfolio construction from Miller's conversation with Morningstar's Christine Benz and Jeff Ptak:

Portfolio Construction and Mitigating Risk

Ptak: Since you mentioned portfolio construction, I thought I would go there next. I think that you've written--when building a portfolio, you shouldn't forecast, but instead should build what you call a portfolio of compensated risk premiums and look to collect free options along the way that might hedge risks. What does that mean in practical terms? Miller: That's a great question, Jeff. I think some of that is taking a look at someone's circumstances in the planning process. And I'll use a hypothetical example here, but one that is maybe more timely and pertinent. When you're working with an individual, and the individual portfolio is intended to cover withdrawals or expenses for the rest of their life, is you take a look at that in a very geeky sense that liability is a real liability in the sense of it adjusts upward and downward for the rate of inflation. Well, that means that potentially when you look at the types of bonds that that client might own in a portfolio, inflation-protected bonds might be a far better fit in that portfolio than nominal bonds. And so, if the market is efficient, the inflation-protected bonds and the nominal bonds should have about the same expected long-term return at any point in time. But the TIPS provide some inflation hedging for the portfolio and is picking up a free option on unexpected inflation shocks to the portfolio. You can take a look at doing something similar various aspects of portfolio for inflation hedging as an example. Arguably, owning perhaps a little more energy or value in a portfolio could potentially help hedge some inflation risks. Owning international stocks denominated in foreign currencies could do the same thing. All of these help further diversify a portfolio and potentially hedge some risks embedded in a client's plan that if the portfolio's implemented in a slightly different way, may not be as successful in eliminating some of those risks.

Inflation Protection in Your Portfolio

Benz: I wanted to follow up on that comment about various inflation-protective investments. We've been hearing so much about inflation, obviously, recently. And I wonder if some investors might be inclined to jump in and out of inflation protection based on how concerned they are about it? Is that a bad way to approach it? Should people have permanent inflation-protective qualities in their portfolio and not try to time their entrances and exits? Miller: Great question. Christine, I think some of that might be dependent on what they're using. So as an example, if someone were to want to use commodities, or gold, or something like that, to potentially hedge inflation risks, there's been a lot of research to show that commodities in and of themselves don't really provide a risk premium. And I'm not sure a permanent allocation to commodities make strategic sense versus something like TIPS or real estate, or foreign stocks denominated in foreign currencies, or even the same with bonds. There's a risk premium there and it probably makes sense to have a strategic long-term allocation that doesn't make sense to time. And I think, as you build a portfolio, the more degrees of freedom and the more choices that you have in how the portfolio is implemented, frankly, the more chances there are to mess it up, and timing is one of those and can be a big one. And so, taking the timing risk out of the portfolio, or even a piece of it, can greatly reduce the harm that can be done to the portfolio. And kind of longer-term strategic risk premiums make a lot more sense of just know why you put it in there. Know that it's going to go through times when it works well, and it doesn't, and try to continue to hold on to it no matter how the performance is.

How Resilient Is Your Portfolio to Inflation?

Ptak: Just to build on Christine's prior question--are you getting a lot of questions from clients right now about how resilient their plan is to inflation? And how are you reassuring them that it is? And are there any changes that you're making in light of recent events, including the uptick in inflation? Miller: Great question. I like to take a look at different scenarios every time we update a plan. And those different scenarios can be anywhere from what happens in a bear market when stocks decline 50%, and what happens to your plan, assuming that that happens, to taking a look at higher inflation and the impact that that can have on your plan. So, some of the conversations are had ahead of time and preemptively to help people understand what happens to their plan, what kind of risks are embedded in their financial plan. And really prepare for these types of events ahead of time, not necessarily that we could predict that they're going to happen. But any financial plan is wrong as soon as you hit "print"--that doesn't mean that it isn't useful. And the way you can make it useful is you simply begin to adjust assumptions that you make and different states of the world and see what happens to the plan. And if there's a scenario or an outcome that is unbearable to the clients or in the plan, that's a really great sign of, this risk needs to be addressed--either self-ensure it, or pay to have this risk insured, or create a portfolio that helps hedge the risk. Specifically, with recent conversations, we've had some conversations about, we expect these types of assets to perform well in periods of inflation. TIPS is a great example; value stocks is another example—an asset that tends to do well during times of inflation. And patting ourselves on the back a little bit about not abandoning value after a decade where it's been very tough to be a value investor and saying, this is why you don't try to time things. It can take decades sometimes for some of the portfolio construction to really pay off.

Risk Capacity and Risk Tolerance

Benz: Speaking of risk, you have said that investing based on risk capacity is superior to investing based on risk tolerance. Can you talk about the distinction between those two things? Because I think some people have questions about that. And also, why do you think it's so? Why do you think that risk capacity is the more important thing to be attuned to? Miller: Great question, Christine. Let me take a second and define each, where I would define risk capacity as the ability for someone's financial plan to absorb downside risks in markets. And the way that I would look at that is, when you do a financial plan, you can create a scenario where it could be anywhere from a run-of-the-mill bear market, to potentially measuring--and I apologize for how geeky this may sound--something like a value at risk, or how likely or unlikely it is that someone's surplus in their financial plan is likely to be wiped out by their existing investment portfolio. All of those are a form of risk capacity-- it's an actual definition, you can measure it--of how likely or how well their plan would do to absorb market risk. Risk tolerance is simply a client's ability to stick with their stated asset allocation or what asset allocation works for how much wiggle they can tolerate month to month or year to year in their investment portfolio. The reason I think risk capacity is likely superior is, one, it's directly measurable; and, second, is we can kind of control it. Risk tolerance can be a little more volatile, it's harder to measure. A lot of studies have shown that risk tolerance is dependent on recent market performance. So, risk tolerance tends to go up when investment performance has been good and down when it's poor. And it's important to respect risk tolerance. But we can actually help control and define risk capacity and ensure that the risk-capacity measure isn't ever really violated in a client's portfolio.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.