What is a Safety Net and How Does It Work? ... Here are all the details!

Higher Risk = Higher Return?

If you are like most investors, you know that investing in the stock market involves risk, and that you could lose money.

Intuitively, you might even think of it simply as “the riskier my investment, the higher the expected returns”.

So what should that mean to you when you choose your investments? I’ll let Financial Economist Prof. William F. Sharpe say it (btw he won the Nobel Prize for his groundbreaking work on the relationship between risk and returns, so you might want to listen up!): 

The bottom line: Yes, Virginia, some investments do have higher expected returns than others. Which ones? Well, by and large they’re the ones that will do the worst in bad times. … If you want more return, you have to take more risk of doing badly in bad times …You can’t just say, “Let’s go for a really hot stock.” That doesn’t guarantee a higher return 
– Prof. William F. Sharpe in Jason Zweig’s CNN Money Interview “Bill Sharpe: The Man That Explained It All” July 6 2007.

 

So it all starts with the risk of doing badly (i.e. losing money) in bad times – the risk of losing money when you can least afford to lose it. The more you can afford to lose at exactly the worst time, the more you should expect to get in return.

So it all starts with how much can you afford to lose at the time you can least afford to lose it? If you want to maximize your returns, you need to start with a clear understanding of your capacity to take on (as in “lose money”) in bad times.

Once you have that number, you can build a portfolio that is broadly diversified but you need to start with your capacity to take risk – i.e. your capacity to lose money in bad times.

So, what’s a Safety Net?

A Safety Net is exactly what it sounds like – a number that you do not want your account to fall below, no matter what happens with Interest rates, the stock market or the bond market.

Think of it as the minimum amount of money that you would consider acceptable in a particular investment account, at a certain point in time in the future.

Alternately, think of it in terms of your “Nightmare Number” or your “Worst – Case Number” for your account … an account level which you simply do not want to imagine having to deal with!

Setting a Safety Net is all about setting that number. More specifically, you set a date in the future – the “target date”, and the number you do not want to be below on that date.

Hmmm … Give me an example

Take the case of Jim.

Assume he has once child, let’s call the kid Jimmy Jr.

Jimmy Jr. is 12, and Jim knows that Jimmy Jr. will likely be heading off to college in 5 years.

Jim estimates that total college expenses in 5 years time will be around $100,000.

So, with his 5 year horizon, a good Safety Net level for Jim can set a Safety Net level anywhere from $100,000 (which would be enough to cover all of his expenses) all the way down to a more modest number, say $50,000 which is the nightmare number … but even at that level, Jimmy Junior will get to go to college even if he has to cover the remaining 50 percent through other means such as a student loan or a scholarship.

So, it’s about making sure you don’t lose too much money?

Sort of. That’s one part of it.

But, a safety net is not just about losing less.

A safety net in investing is very much like using a safety harness in rock climbing. You don’t wear a safety harness because you hope to fall and end up dangling from a rope. You wear a safety harness while rock climbing because the security of knowing there is a safety net allows you to be more confident and to reach higher.

In investing, the establishment of the safety net allows the engine to allocate your cash more efficiently and accurately between performance-seeking assets such as stocks, and safer assets such as government bonds.

It’s not just about losing less, it’s just as much about winning more.

So, how does it work?

One way to think about how it works is to view it as an intelligent, always-watching investment engine. It’s intelligent because unlike an ad-hoc 60/40 or other mix of stocks and bonds, the engine looks at your account value, how much time you have left and what the safety net level is, and then uses that information to come up with a customized allocation between:

(i) a well diversified mix of equities (stocks) that are designed for performance but also carry risk of losing money, and,

(ii) a mix of ultra-low risk mix of U.S. Treasury Bonds that are matched to your investment horizon to try and eliminate interest rate risk

If you have a lot of time, or have a comfortable cushion in the account compared to your safety net level, the engine allocates a larger amount to the performance component. If on the other hand, you neither have the time nor the margin of error (i.e. too small a cushion compared to your safety net) then the engine allocates a lot more to the safe US Treasury portion. Most importantly, the engine watches your account regularly, trading as efficiently as it can to avoid your nightmare scenario, minimize tax effects and maximize your account value.

What if I don’t want to lose any money, but I can afford to wait a while?

Well, you can still work with the time value of money.

That’s a fancy way of saying, that a dollar tomorrow is worth more than a dollar today, because of the interest you will earn on that dollar in a ultra-low-risk investment such as the U.S. Treasury Bond.

So, if you have $100,000 and want to make sure that you’ll still have $100,000 10 years from now, you still have the ability to lose some money between now and ten years from now. That means that although you don’t want to have lost any money at the Target Date (in this example, 10 years from now) you actually do have some capacity to lose money as long as you can make it back by the Target Date.

Why do you need a Target Date?

The target date is critical because it tells us how much time we have to try and grow the account. The engine tries to makes sure that the amount of money in the account plus all the interest that the account will earn from the bonds in the account prior to the target date will add up to more than the safety net level.

If it is able to do that right, then you can be reasonably confident that when the target date arrives, the account will be greater than the safety net level. 

How about before the target date?

It is entirely possible that your account could dip below your safety net prior to your target date (also known as horizon date). However, the system will always try and make sure that your account value plus any interest you are scheduled to collect from your Treasury Bonds before your Target Date will add up to a number above your Safety Net.

The job of the engine is to make sure that the account mix is always adjusted to try and secure that worst -case safety net number by the target date. 

How often is this adjustment made?

Although the account is constantly being monitored, most trades happen once a quarter. Occasionally, we’ll trade more or less often, and when the account is traded, it’s done with the aim of minimizing tax impact (minimizing short term capital gains, and sheltering long term capital gains). Further tax optimization occurs through a process called Tax Loss Harvesting. 

Can you guarantee I won’t end up below my Safety Net at the target date?

No. The system is designed to minimize the chance of that occurring, and is based on sophisticated techniques that the largest and most sophisticated investors have used for decades (e.g. Liability Drive Investing, Asset Liability Management and Dynamic Asset Allocation techniques such as CPPI ). However, there is always a possibility, however small, that you might end up below your Safety Net.