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Managing Personal Wealth in Volatile Markets

An ERM Approach

Jerry A. Miccolis, CFA®, CFP®, FCASMarch 15, 2011

Call 800.364.2468 :: Visit brintoneaton.com 1

By way of (re)introduction…

Principal & Chief Investment Officer, Brinton Eaton Wealth Advisors

Former Principal & ERM Global Practice Leader, Towers Perrin Former Chair, CAS ERM Committee Author/co-author:

Asset Allocation For Dummies® (Wiley, May 2009) Enterprise Risk Management: Trends and Emerging Practices (IIA, June

2001) Related publications

Member of the Financial Planning Association (FPA) and the New York Society of Security Analysts (NYSSA)

35+ years of actuarial, risk management, and investment experience

A brief overview of today’s discussion

Personal wealth management is risk management ERM is the natural conceptual framework to build

and protect wealth This has certain implications Investment strategy needs to

be focused on the right goals MPT needs modernization Asset allocation needs to be

dynamic Catastrophe protection needs

to be creative

All this is achievable with currently available tools

Ask questions!

Investing has always been an exercise in taking, and managing, risk

But, the game has changed DB plans DC plans, 401(k)s

Underfunded Social Security

Risk-shifting to the individual investor

Now, more than ever, wealth management IS risk management

And the risks are substantial 2008 — a wake-up call; contagion like never before

It can happen again

Fault lines in MPT have been starkly exposed Something more is needed

Enter ERM

MPT ERM MPT ERM owes a lot to MPT

It’s time for ERM to return the favor

Premise: the core principles of ERM can form the basis for successfully building personal wealth

Build on four key “pillars” of ERM Strategic focus

Natural hedging

Risk exploitation

Catastrophe protection

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These four pillars support a strong bridge —between corporate and personal best practices

ERM Pillar Organizational ERM Individual ERM

Strategic FocusCustomize risk management around, and

in service to, the organization’s specific

strategic objectives

Customize your investment strategy around

your own unique long-term financial objectives

— which is the real purpose of your investments

Natural HedgingLook across operational silos to find risky

operations that offset each other

Diversify and allocate investments among

uncorrelated asset classes — using up-to-date

Risk ExploitationUse the ERM-enlightened view to do

informed risk-taking, exploiting areas

deemed “too risky” by competitors

Employ informed risk-taking to exploit high-

performing but risky assets — making volatility

work for you

Catastrophe ProtectionTransfer only those risks that can’t

naturally be hedged away, and insure

those risks only at catastrophic levels

Use “safety net” portfolio protection as

catastrophe insurance against major market

shocks that diversification can’t handle — and

in a cost-effective wayBrinton Eaton, 2011

Strategic Focus

work for you

What’s your situation?

Retirement Objectives

Lifestyle Requirements

IncomeSources

Investable Assets

Risk Tolerance

PlanningHorizon

Charitable Inclinations

Gifting/estate Intentions

Tax Status

Investment Constraints

What’s riskier?

Hard Luck Harry has a choice to make

Risk doesn’t exist in a vacuum

Lifetime Cash Flow Projections – Assumptions

Lifetime Cash Flow Projections – Results

The results can be counter-intuitive

Confidence Level

Beginning Investment Strategy

Ending Investment Strategy

Illustrative Client Example

Strategic Focus — Recap

Customize your investment strategy around your own unique long-term financial objectives — which is the real purpose of your investments

Your financial situation has many moving parts

Financial planning tools can capture the complexities in a coherent way

The right investment strategy is the one that best secures your own financial future

Natural Hedging

work for you

MPT — the beginning

Conceptual breakthrough Risk/return tradeoff Asset class correlations Efficient frontier Prudent Investor Rule

MVO Single period Everything is Normal Risk is standard deviation Efficient frontier derived via

closed-form solution Can solve equation by hand Useful in the 1950s!

MPT evolves

High-speed computing MVC-based simulation Non-normality Fat tails Multiple periods Compound returns/risk drag Rules-based rebalancing More realistic risk measures

Shortfall risk Conditional VaR

MPT has come a long way…

…but it’s still only as good as its assumptions

MVC — Mean/Variance/Covariance Mean Expected asset class returns move in cycles

Momentum/mean reversion

Valuation

Variance Volatility is not constant

Clustering

Covariance Correlation — does it really measure what matters?

-1 -0.5 0 0.5 1

Correlation — it gets the obvious cases right

ρ = +1 ρ = -1

ρ = 0

-1 -0.5 0 0.5 1

Correlation — does it measure what matters?

ρ = 0 ρ = 0

ρ = …you name it! ρ = 0

Correlation — can it mislead?

ρ = +0.95

Correlation — what would Scooby Doo say?

“ruh ρ!”

“While the Pearson Rho correlation coefficient serves the limited purpose of quantifying the degree of linear relationship between random variables, the actual relationship among asset classes is sufficiently complex that a measure more robust, observant, relevant, asymmetric, multi-dimensional, and dynamic is needed to capture the deep, imbedded, structural relationship among those asset classes”

Clearly, improvements in MPT tools and techniques are needed

Correlations copulas

MVC (statistical) models structural models Parameter risk ARMA — momentum/mean reversion GARCH — volatility in volatility, clustering Risk budgeting Regime-based optimization

-1 -0.5 0 0.5 1

ρρ ρρ ρ ρρ ρ ρ ρ

Natural Hedging — Recap

Diversify and allocate investments among uncorrelated asset classes — using up-to-date tools

MPT is still the right conceptual framework

But, most applications are very much out of date

The needed tools are available

Risk Exploitation

work for you

Diversification reduces risk…

0 1 2 3 4 5 6 7 8 9 10Year

Asset A

Asset B

50/50 Mix

…Rebalancing improves return

0 1 2 3 4 5 6 7 8 9 10Year

Asset A

Asset B

50/50 Mix

Rebalanced 50/50 Mix

What about in real life?

S&P 500US RE

Diversification reduces risk in real life too…

1980 - 2009 Results

15.0% 16.0% 17.0% 18.0% 19.0% 20.0%

S&P 500US Real EstateCombined 50/50

…and it also improves return

1980 - 2009 Results

15.0% 16.0% 17.0% 18.0% 19.0% 20.0%

S&P 500US Real EstateCombined 50/50Combined w/ rebalancing

Rebalancing puts the inherent volatility among assets to work for you

The more volatile your assets, the more mileage you get from rebalancing

The more distance your pistons travel, the more powerful your engine

There is a more proactive way to exploit risk

Dynamic asset allocation Explicitly treats momentum/mean reversion Utilizes early warning indicators

Signals can be internal and external Moving average algorithms Valuation measures

DAA reflects the fact that MPT is only as good as its assumptions Recognizes that assumptions can change dynamically Structurally sound way to:

Test your foundational assumptions Nimbly make adjustments as appropriate

Leading Economic Indicators Credit spreads/money flows

Sector rotation is an example of DAA

100.00

120.00

140.00

160.00

Risk Exploitation — Recap

Employ informed risk-taking to exploit high-performing but risky assets — making volatility work for you

Rebalancing is the classic way to exploit volatility

Dynamic asset allocation takes rebalancing to the next level

You can capture higher returns than those investors who have a less enlightened risk perspective

Catastrophe Protection

work for you

Traditional ways to protect portfolios are not enough

High allocation to cash / US Treasuries

Precious metals

Annuities

Puts / collars

More creative approaches are needed

Additional portfolio diversifiers Market neutral/absolute return strategies

Commodity momentum plays

Portfolio safety nets Hybrid puts

Correlation plays

Volatility plays

Buyer beware

Criteria for an effective safety net

Sudden appreciation in severe market downturns “Severe” denoting sudden, substantial, unexpected decline in

market value across most major asset classes, as in 4Q08 (i.e., when diversification doesn’t help)

Appreciation to a degree sufficient to meaningfully offset the decline No “give-back” during market recovery!

Very low cost Minimize diversion of funds from productive use No sacrifice of upside portfolio potential I.e., it is “insurance” we expect not to use

Minimal disruption to portfolio Maintain what works in vastly more likely markets “Don’t throw the baby out with the bathwater”

The criteria in a picture

Nov-98

Nov-99

Nov-00

Nov-01

Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

Effect on the portfolio

Nov-98

Nov-99

Nov-00

Nov-01

Nov-02

Nov-03

Nov-04

Nov-05

Nov-06

Nov-07

Nov-08

Nov-09

How does it work?

Volatility “swap” “Buys” daily volatility

“Sells” weekly volatility

Published index; transparent formula

Accessed via a structured note 1X exposure to S&P 500

Stock Index

3X exposure to swap index

S&P 500 Total Return Index 9/22/10-9/28/10

9/22/2010 9/23/2010 9/24/2010 9/25/2010 9/26/2010 9/27/2010 9/28/2010

Catastrophe Protection — Recap

Use “safety net” portfolio protection as catastrophe insurance against major market shocks that diversification can’t handle — and in a cost-effective way

Treat only those risks that asset allocation/ rebalancing aren’t designed to cover

Think outside the box, as traditional risk hedges are inferior on several levels

Have we covered all the bases?

Personal wealth management is risk management ERM is the natural conceptual framework to build

and protect wealth This has certain implications Investment strategy needs to

be focused on the right goals MPT needs modernization Asset allocation needs to be

dynamic Catastrophe protection needs

to be creative

All this is achievable with currently available tools

Ask questions!

For more information on these ideas…

Read: AssetAllocationBook.com Visit: www.brintoneaton.com Library

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