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, | February 5, 2019

  • Activating the Portfolio Reserve is about helping you stay the course with your portfolio
  • The decision to activate depends, in part, on the potential trade-offs you are willing to make
  • Analysis of past market returns shows that a 15% correction is a reasonable trigger for a discussion

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For most Goals Driven Wealth Management clients, meeting annual lifestyle needs is the top priority. This core lifestyle goal is funded by a dynamic asset allocation of risk-control assets within the Portfolio Reserve and risk assets. The Portfolio Reserve is composed of cash and high-grade bonds — "safe assets." It is designed to fund high-priority lifestyle consumption for a preferred number of years in a lifetime — through both normal times and periods of market distress. It offers a more intuitive way to express risk preference while helping to avoid common behavioral mistakes.


A simple approach to selecting the number of years of Portfolio Reserve is to start with risk capacity, the maximum number of years of lifetime consumption that can be funded by safe assets with no expected shortfall. The number of years of Reserve might then be modified downward to align with a different risk preference. Common reasons to modify the Reserve are to express a higher tolerance for risk, add non-lifestyle goals, increase consumption or create a buffer of surplus assets. Once risk preference is determined, the asset allocation is managed to the goal-aligned target as goals are funded through time.

Portfolio returns are the reward (on average) for bearing risk. In competitive capital markets, risk manifests itself with the introduction of new information, which sometimes results in significant drawdowns and market distress. Periods of market distress require revisiting the tools of portfolio risk management, such as activating the Portfolio Reserve to fund lifestyle exclusively from safe assets. When the Portfolio Reserve is activated, Portfolio Reserve assets are slowly drawn down to fund lifestyle. Activating the Reserve stops the process of selling risk assets to replenish the Portfolio Reserve. The decision to activate the Reserve is not about timing the market. Rather, it helps investors stay the course with their overall investment and wealth plan, giving risk assets time to recover lost value.

Capital markets are highly competitive pricing engines that attempt to price a positive relationship between expected return and risk. Risk assets should have a higher expected return than risk-control assets to compensate for that risk, even during periods of market distress. Another implication of competitive markets is that short-term returns are unpredictable. Research based on equity returns since 1926 shows that there is a 0% relationship between prior and subsequent quarterly (or annual) returns.1 Investors are better off staying the course than timing markets, provided their assets, goals and risk preferences are aligned.


The decision to activate the Portfolio Reserve during market distress is first and foremost a personal decision. It depends on asset sufficiency, the size of the Reserve, potential trade-offs related to goals, and individual preferences. Even though Goals Driven Wealth Management provides a personalized asset allocation based on unique assets, goals and risk preferences, some investors may still want objective guidance about when to activate the Reserve. Historically, spikes in market volatility accompanied with a drawdown in risk-asset values have been associated with market distress.

Equity markets have high average expected risk, which has spiked during historical periods of market distress. Risk can be measured by dispersion in past returns (realized volatility) or expected dispersion in future returns (implied volatility). Exhibit 1 shows volatility as realized by global equities and implied for U.S. equities. Spikes in volatility significantly above average have coincided with historical periods of market distress, while periods of stabilization have been accompanied by falling volatility.

While short-term returns are unpredictable, there is evidence for longer-term predictability (e.g., three to seven years) in risk-asset returns due to mean reversion. When looking specifically at nominal U.S. equity returns since 1926, Exhibit 2 shows that 4.3% of quarters breached a -15% quarterly return threshold. During those quarters the average total return was -21.9%, representing a -2.3 standard deviation event. Over the following five years, on average, markets realized an 11.2% compounded annualized return, which compares to the historical average of 10.3%. Exhibit 2 shows the same relationship in both nominal and real returns, in the United States and globally. This demonstrates that risk and return remain related even during periods of market distress, and that activating the Portfolio Reserve and staying the course with the risk-asset allocation potentially earns above average returns. Additionally, these periods of market decline coincide with spikes in volatility. Because of this, we find that breaching a -15% drawdown threshold accompanied with a two standard deviation spike in volatility is a good signal to consider activating the Portfolio Reserve.

In the United States, 11 discrete periods (some of which lasted multiple quarters) had a -15% or more correction from the prior peak, based on monthly returns. On average during these unique periods of market distress, the length of peak-to-trough declines was 15 months, with a cumulative return of –33.5%. After activating the Portfolio Reserve, the average cumulative return was 89.2% over an average recovery period of 37 months from initial trigger until regaining the prior market peak.3

All major historic stress events, from the Great Depression to the 2008 Global Financial Crisis, caused the equity market to contract more than 15%.4 Exhibit 3 shows it took the U.S. equity market eight months to decline 15% from its October 2007 peak. If the Portfolio Reserve (displayed at the bottom of the chart) was activated at this trigger point, it could have funded lifestyle consumption not only through an additional eight months of worsening distress (-41.5% cumulative return), but also through the time to recovery or until volatility stabilized at levels close to its historical average. Over the 45 months from trigger to recovery, the compounded average annual return of the U.S. equity market was 4.9%. While this is below the 10.3% historical average annual return, it is substantially positive and much more than the 0.2% average annual return for cash (30-day T-Bills) over the period. It also would have allowed the portfolio to fully recover lost value, something that did not happen for investors who sold risk assets for cash.

Market stress events are difficult to identify in advance. While we can't predict how markets will act during stress environments, we can manage the risk and how it may affect an investor's ability to fund goals. In Goals Driven Wealth Management, activating the Portfolio Reserve helps manage risk during stress events. Once activated, the Portfolio Reserve securely funds lifestyle needs while maintaining the portfolio's risk-asset exposure. This allows the investor to stay the course with their goals-based strategy while risk assets potentially earn a higher expected return and recover lost value.

Ultimately, a drawdown of -15% or more in price levels accompanied with a two standard deviation spike in volatility is not a prescription to activate the Portfolio Reserve, per se. But it is a catalyst for a discussion about potentially activating the Reserve. Client circumstances will vary based on Reserve length, sufficiency, and individual preferences. When conditions stabilize — as indicated by some meaningful recovery in risk-asset values and normalization in volatility — new information will be available to revisit assets, goals and risk preferences more rationally. Some clients will choose to adapt and reset their investment and wealth plan, deactivating the Portfolio Reserve. Others will choose to maintain Reserve activation in anticipation of a more complete recovery in risk-asset values. But ultimately, adaptation based on informed decision-making is central to the Goals Driven Wealth Management process.

1Based on tests of serial correlation using Ibbotson US Large Stock index returns from 1926 to 2018. Source: Morningstar, Northern Trust Research.
2We use Ibbotson Associates U.S. Large Stock Total Return Index since 1926 for U.S. markets and MSCI World Total Return since 1970 for developed markets.
3Nearly half of the 89.2% average cumulative return of the 11 discrete periods of market stress is attributed to the Great Depression, which had a return of over 500% from its trough to the prior market peak.
4Significant equity-market stress events modeled in the GPS application include: Great Depression, 1970's Bear Market, 1987 Market Crash, Technology Bubble and the Financial Crisis.

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Portfolio Reserve Activation