What’s The Appropriate Risk Level In Your Investment Portfolio? Order A Tesla.

Have you ever purchased a Tesla automobile?  The ordering process is rather remarkable: your car is custom made to your specifications, then either delivered to your nearest service center or directly to your front door.  Every option, from paint to battery to roof to wheels, is designed by you.  Tesla eschews the days of shopping from the limited inventory of an automaker car lot, an experience that invites compromise in favor of immediacy (“I can drive it home today!”).  The Tesla ordering process requires an investment of time, energy, and patience by the purchaser to document what he/she wants and then wait while the car is manufactured and delivered.  While this approach might drive the stereotypical social-media gorging Millenial to the looney bin, it likely contributes to Tesla’s high customer satisfaction ratings, as it engages the consumer, with their input at the forefront, encouraging satisfaction with an outcome of their own making.  Would you rather have a product sold to you or designed by you? 

The best process for the allocation of your investment portfolio is no different than ordering a Tesla.  It first requires input from you along six axes:

1) Current inventory of assets (homes, cars, investment securities, retirement benefits, etc.)4) Projected future earnings and net savings
2) Current inventory of liabilities (monthly fixed and variable expenses, including outstanding debt)5) Financial and life goals (including large discretionary purchases, family size, education, and retirement)
3) Current age and projected lifespan (health factors, etc.)6) Investment risk preferences

With these variables defined, a financial professional can lead you through finalization of the “car” specifications.  By defining the aspects of the future you envision, especially your life goals, the probability of achieving them can be quantified and adjusted, just as you change the car options and view them on a virtual image while weighing their costs. 

What you want vs. What you can afford

You want to buy a house in five years, but you aren’t saving much and you have an aversion to investment risk?  You will likely need to spend less now and increase your investment risk appetite to meet the goal.  You’re 50 years old and want to retire at 60, but your asset balances are average for your age and income, you are in good health with a long expected lifespan, and you also want to buy an expensive boat in two years?  You will likely need to compromise on the new boat purchase or target a later retirement age, or both.  And so goes the configuration process: it’s a give and take based on what you have and what you want, often in concert with software that can quantify risk and return probabilities, encapsulate variables like negative sequence of returns risk, and project cash flows based on savings, costs, and asset flows.  This process can produce a probability of success score for each goal, quantifying the impact of the specifications you choose.

Let’s distill these examples even further.  What “options” on the “car” can you really control?  Recall the 6 axes defined above.  Three of them can change moving forward (Dynamic column), while the other three (Static column) are fixed at the point of analysis, like standard equipment on every “car” model.  Thus, choosing the right “car” is really an exercise in moving three financial levers: savings, goals, and investment risk.  Further, two of those levers, savings and investment risk, have limits on their spectrum: only so much of future earnings can be saved (given reasonable spending needs), and only so much investment risk can be taken (without borrowing/leverage, which is another subject entirely).  The lever with the most flexibility: financial/life goals.  Thus, financial planning is an exercise in setting reasonable goals given limits in what can be achieved through savings and returns on invested assets.   Other preferences around savings and investment risk may also reduce your life goals, such as wanting a high standard of current living or a low risk investment portfolio for peace of mind.   Of course, the “standard equipment”, like a high current level of assets (perhaps inherited or earned through your career) or young age, may help to facilitate your life goals.  The point is to go through the detailed process of understanding the “standard equipment” and picking the “options” on the “car” until you determine a model that you can accept… and afford.  

Once you’ve come to a good conclusion on reasonable specifications for the “car”, it’s sent off to the manufacturing plant for assembly.  It’s here where the appropriate investment risk model is married to your accepted goals and financial variables.  As a best practice, the risk models are delineated by “high risk” and “low risk”, where the most important factor in the model is the proportion of assets allocated to each category, with the “high risk” category offering a higher expected return at the expense of greater investment return variability.  Engineering of the asset classes that lie within each category, and, to a lesser extent, the underlying investments themselves, can add value to the assembly of the “car”, but by far the most important decision, one that has the greatest effect on portfolio returns, is the allocation of assets to “high risk” investments vs. “low risk” investments.  In the Tesla metaphor, the correct “assembly line” (risk model) to produce the “car” (risk:return ratio, savings rate, goals, etc.) you need was determined in the configuration process described above.  The investment advisor’s job is to flip the right switch, initiate the right assembly, and maintain the “plant and equipment” (research and analysis on asset categories, classes and investment options) so that the car is produced with minimal defects.   Once in service, ongoing “car maintenance” (risk rebalancing, tax loss harvesting, risk model calibration, etc.) is necessary, but Tesla being the innovator that it is, many of these updates are delivered remotely through a software upgrade to its operating system!  So, too, should an advisor’s service offerings be minimally invasive to you, occuring in the background while the “car” continues to run.

Of important note, the Tesla you buy today may not be the Tesla you need at a future point in time.   For instance, the investment risk model that’s appropriate during the asset accumulation (working) phase of your life may be fundamentally different than the one you need during decumulation (retirement).  A viable risk planning strategy is to accumulate to the point that an assumed “low risk” return on a portion of your asset base (including Social Security, defined benefit pensions, annuities, etc.) covers your essential retirement expenses, assumed inflation, and taxes, with the residual allocated to “high risk.”  Prior to that point, an aggressive risk profile across the asset base, paired with a savings strategy, may be appropriate to grow the nest egg to an acceptable level.  Thus, allocation of investment risk is a living, breathing exercise that requires regular analysis, especially as you approach and achieve major financial goals or life circumstances change.  

Elon Musk built Tesla, Inc., into a car (and energy/storage) company that has more equity value than competitors that produce 100 times as many cars.  It did so by tailoring each car to its customers’ needs based on their input, gaining their buy-in during the configuration process, and retaining it through superior manufacturing, maintenance and service offerings.  Use this paradigm when thinking through your financial life.  Know that the goals you achieve are based on the goals that you design; make sure your circumstances drive the design, and be an active participant and decision maker in that process.  Choose an advisor with an assembly plant that has a robust investment risk model as the manufacturing equipment and a maintenance and service offering that makes necessary changes and updates with minimal inconvenience to you.  Finally, make sure to assess your “car” needs at inflection points in your life, especially around retirement and other financial goals.   In short, go order and own a Tesla: it’s the best financial blueprint out there.  

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