Asset Allocation Loss Ratio (AALR) – What Is It & How Does It Help You?

When you go to any investment firm, they require you to fill out & sign a Risk Tolerance Questionnaire of some kind. The purpose is to prevent you from investing too aggressively.

This can be important, because you might sell a more aggressive investment when it is down and lose money.

However, there are 2 important questions:

–          What prevents you from investing too conservatively?

–          Can you achieve your life goals with the more conservative investments?

These are critical questions, since almost nobody can retire comfortably with a typical balanced portfolio with 40-50% in bonds. For example:

• A couple earning $100,000/year together saving to retire on $80,000/year in 30 years with a balanced portfolio earning 5%/year would need to invest $34,000/year! Impossible!

This is where the AALR comes in. With any financial decision, it’s important to understand how it affects your life – both the risk & the return.

The Asset Allocation Loss Ratio (AALR) estimates the effect of a more conservative portfolio or suboptimal asset allocation on your long-term investment returns.

To see the effect, we need a comparison with a core investment that is not conservative. The best measure is a broad stock market index, such as MSCI World Index. Stocks are the most reliable long-term investment for retirement planning and the world is the broadest index.

The formula for the AALR:

AALR = Expected return of core non-conservative portfolio – Expected return of your portfolio

If equities conservatively long-term make 8%/year and bonds 4%/year, then having 25% in bonds reduces your expected return from 8%/year to 7%/year. This is an AALR of 1%.

Similarly, a balanced portfolio with 50% stocks & 50% bonds = AALR of 2%/year.

An AALR can result from adding bonds or fixed income to your portfolio, or suboptimal investments such as having too much in tiny Canada or focusing on low volatile or income stocks.

Many investors, especially index investors, try to avoid paying for advice with an MER, but lose their savings with their AALR. A low-cost index investment might save 1%/year with a lower Management Expense Ratio (MER), but if they invest 25% in bonds, they lose 1% return with their AALR (Asset Allocation Loss Ratio).

This lower return is, of course, an estimate. However, it helps you understand the tradeoff.

You fill out a Risk Tolerance Questionnaire and it says you are “moderate” or “conservative”, so you end up with 25% or 50% in bonds or other fixed income.

You gain: A feeling of security. Less volatile investments that should decline less in down markets.

You lose: Freedom. Lower return investments and less freedom in your future.

It’s critical for you to understand both sides to your decision to invest more conservatively.

The next step is to see how the lower return affects your Financial Plan. How much less is your retirement income expected to be? Can you still live the future you want?

Only a Financial Plan will tell you for sure. However, you can estimate it with the return comparison until you retire and for your expected life.

For example, if you are 30, plan to retire at 60 and expect to live to age 90:

Return  Today            In 30 years     In 60 years

8%/year         $100,000       $1 million       $10.1 million

7%/year         $100,000       $760,000       $5.8 million

You get 25% less when you retire and 40% less over your life with a 1%/year lower return.

What is the alternative? Learn to have a higher risk tolerance.

Risk tolerance is a learned skill.

Risk tolerance = Ability to do nothing when your investments are down.

How can you learn to have higher risk tolerance? Study the stock market long-term to understand how often & how far it falls, & how long it takes to recover. Learn to what extent you can be confident in it long-term. Get professional advice and work with a financial planner that can help you stay invested, if that is helpful for you.

If you panic and sell your investments after a major decline just once in your life and a financial planner helps you stay invested, that alone could pay for the financial planner for 30 years.

Let’s take a quick look at risk of the stock market. We have the best records for the US market, S&P500. It has historically fallen 20% every few years, 30% about once per decade, & 40% once every 3 or 4 decades. 88% of declines are fully recovered in 1 or 2 years. The worst calendar 25-year return of the S&P in the modern stock market (since 1930) is 8%/year. Note that is the worst return.

Many people don’t think much about their money and tend to get labelled as conservative investors because they think the stock market is riskier than it actually is.

For example, John & Jen earn $100,000 each ($200,000/year together). They want to retire in 30 years on $150,000/year. We will use 3% inflation & maximum government pensions. With a 100% equity portfolio earning 8%/year, they can achieve it by investing $2,700/month. This is essentially maximizing their RRSP rooms.

They go to a financial planner, bank, roboadvisors or discount brokerage firm and fill out a Risk Tolerance Questionnaire. It says they are “moderate”, so they are recommended 25% bonds & 75% equities. This gives them an AALR of 1%, since their expected return is 7%/year instead of 8%/year.

They gain: Lower volatility. The worst 1-year decline of their portfolio is 20%, instead of 40% with the 100% equity portfolio.

They lose: Growth. They invest the same $2,700/month. When they retire, they can only afford $125,000/year, not $150,000/year.

The tradeoff question is: Do they need the lower volatility to stay invested, OR can they learn to tolerate the higher volatility and get $25,000/year more for their entire retirement?

When you see both sides of this tradeoff accurately & how they affect your life, only then can you make a smart decision about what is best for you.

To invest wisely, it’s not enough to just fill out a Risk Tolerance Questionnaire. It helps you avoid investing too aggressively, but might make you invest too conservatively.

Know your AALR. Be in control of your life. Understand how the lower return of more conservative investments will affect your life.

Ed