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Posted by Brett Gustafson on Apr 11th, 2024

Portfolios With a Purpose – Optimization

When it comes to portfolios, you often hear the term "optimize" thrown around, but what does it really mean to "optimize” a portfolio? Sure, there are methods involving complex models using historical data and assumptions, but don't let the fancy jargon sway you. There are countless future influences, such as changing market conditions, economic factors, and personal circumstances, that will have a major impact on your investing journey. Not to mention that we all know that “past performance does not indicate future results.” The optimized portfolio comes down to a few things, most notably, you and your desired risk level. The optimal portfolio will need to consider your age, desired income level, and risk tolerance. Typically, this results in investing in one of three or five portfolio risk tolerances offered. ‘Optimizing your portfolio’ has a nice ring to it and brings with it the ability to impress some clients. But in practicality, the definition comes down to designing a well-diversified portfolio that maximizes returns while maintaining a risk level the investor is comfortable with, even if the future level of market risk is unknown.

Let’s take the 2010s as an example; the optimized portfolio to simply maximize returns during this time period would have been 100% US equities. But psychologically, I am sure there were not too many portfolio managers running around offering 100% US equity portfolios, given what portfolios went through during the Great Financial Crisis. Investing is all about balancing risk and return to achieve your long-term goals. I think everyone understands returns (especially when they're negative), but what about risk? In finance, the most popular approach incorporates the volatility or standard deviation of an investment's returns. Standard deviation may sound a bit math-y, but if you break down the term (standard = average and deviation = dispersion), it is just a measure of the variability of returns. Of course, many more metrics have become common, including downside deviation, up/down market capture, and drawdown. Really, they are all trying to paint a picture of the risk of an investment based on its variability of returns. But is that 'risk'?

Take risk-adjusted returns such as the popular Sharpe ratio (return above the risk-free rate divided by volatility). Both investments A & B in the chart below have the same return over the period; however, A takes a much more volatile path to reach the same destination. Does that make B better than A? B certainly has a higher Sharpe ratio, but both result in the same wealth creation. This is where risk really depends on you, the investor.

If you agree that risk is not just a function of volatility but of the investor, below we explore investor characteristics that also determine risk.

Behavioural fortitude—Investing is an emotional endeavour, probably because we all care pretty deeply about our wealth. Greater volatility increases the risk of making a behavioural mistake when investing. On those big upswings, the fear of missing out (FOMO) may encourage adding more or taking on more risk. Conversely, during those downswings, the pain of losses (unrealized) can become realized losses if an investor capitulates. 

If you are more likely to make a behavioural mistake due to market volatility (up or down), investments that are more volatile increase the risk of you making this kind of mistake. This applies to all investors, young or old, wealthy or less wealthy. If you have a greater fortitude to remain the course during periods of volatility, this is less of a risk.

Accumulation phase – For those with a long time horizon and who are currently in the accumulation phase, meaning net savings and regular contributions to your portfolio, volatility is less meaningful as a measure of risk. Simply put, the longer the accumulation phase remains for an investor, the less impact market volatility will have, and the long-term return rate will be much more important. It is the destination that is important, not so much the journey. Instead, the focus should be more on wealth creation, saving more, and generating a healthy return.

Critical 10 - The term critical 10 is often used to describe the final five years of accumulation and the first five years of decumulation. Different risks begin to arise during this phase and will last into the decumulation phase.

  • Valuation risk – As this phase likely includes the years of maximum savings rate, valuations matter even more. If equity markets are elevated, perhaps late in a bull cycle, the risk is your maximum contribution coinciding with buying high. Bonds, too, if yields are low; the risk is committing capital with a low expected future return.
  • Expenses – When you are working and saving, it is hard to quantify what your living expenses will be after work is finished. On a beach, on a boat, or at home watching daytime TV. This Critical 10 period starts to provide a glimpse into what these expenses may look like. However, since it is a transition phase, much of it is based on guesses.
  • Volatility starts to become a bigger risk – without the buffer of regular savings and a long time horizon, a bear market/significant wealth decline becomes more challenging. Both from a portfolio recovery perspective and for your longer-term financial plan.

Decumulation phase – Ah, the golden years. Unfortunately, the golden years also come with more types of risk.

  • Cost inflation – Some simple math can have a $2m portfolio, with a 5% annual return, that lasts about 32 years, with a starting withdrawal rate of $100k that goes up 2% per year (inflation). If cost inflation is 5%, it lasts 22 years, a decade less. For the savvier financial planners, please excuse the simple math we are using to help articulate the point. With inflation likely higher in years ahead than it has been for the past few decades, this is a new risk (or an old risk that is pertinent again). Taking on more risk to generate higher returns helps lessen 'cost inflation' risk, but with that comes greater market risk.
  • Spending volatility – Spending during the decumulation phase is not smooth. In the early years, there was probably more spending, travel, etc. In the middle years, that spending may decline, and playing bridge is a low-cost activity (unless you have added a few dollars per point). But in the late years, there could be added medical expenses.
  • Longevity – The risk of living longer (a good thing but a planning risk). When more individuals had a defined benefit pension, invested in pension-like vehicles, or had kids that would allow them to move in, living too long wasn't as much of a risk. Today, it is. Most rely on having a buffer in their plan. Living longer means the estate is smaller. But living longer magnifies all the other risk factors.
  • Market volatility is a big risk – As the decumulation phase progresses, a market drawdown becomes an increasing risk to any plan. Shedding market risk is an option, but this increases other risks, such as keeping up with cost inflation, spending volatility, and living longer.

The above graphic is for illustrative purposes only as everyone's journey is different, and of course, there are many additional factors. The goal is to highlight that risks do change over time, and it goes beyond simple 'market risk' or volatility. This outlines just how challenging it is to “optimize” a portfolio for an investor.   

Final Thoughts

The pursuit of portfolio optimization is fundamentally a task to strike a balance between risk and return in accordance with a client’s overall objectives. Reasonable return goals are achievable over the long run, but optimizing portfolios for risk is the element that presents the most challenges. There are always investors who want more return, but once you bring up the notion of added risk, the goals tend to change. The landscape of risk is multifaceted; not only do we have market volatility to deal with, but also the behavioural fortitude of the investor on top of that. From accumulation to decumulation, each era brings with it its own set of challenges and characteristics. Despite our best efforts to quantify and mitigate these risks, there will always be uncertainties in the marketplace, and I can assure you none of us can see the future. Therefore, the true essence of portfolio optimization does not come from historical data and assumptions but rather from our ability to navigate the many risks throughout our investing lifecycle in pursuit of our long-term financial goals.

— Brett Gustafson is a Portfolio Analyst at Purpose Investments

— Craig Basinger is the Chief Market Strategist at Purpose Investments

Insights with Purpose

At Purpose, we are attempting to change the status quo within the investment industry. Mainly, the enigmatic standards by which the industry operates. We are an open book when it comes to portfolio design and discussions surrounding our outlook and strategies. We want to make managing portfolios simpler for advisors and act as a sounding board for ideas. We start by running portfolio comparisons between your portfolios and ours. Not to say ours is right and what you are doing is wrong, but to understand the differences and have discussions surrounding the rationales. We aim to keep this discussion going quarterly; this is not a one-and-done service. We want to build our relationships with advisors so that the end client has a satisfactory investment experience.

If you want to know what exposures your portfolio is tilted toward, feel free to reach out to our team.  As the great Peter Lynch once said, “Know what you own and why you own it." 

Sources: Charts are sourced to Bloomberg L.P.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold, or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees, and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements ("FLS") are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as "may," "will," "should," "could," "expect," "anticipate," intend," "plan," "believe," "estimate" or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.


Brett Gustafson

Brett is a Portfolio Analyst at Purpose. He is responsible for relationship management and advisor support and focuses heavily on portfolio analytics for advisors, our own proprietary models, as well as equity research. With over nine years of experience in the investment industry, Brett started his career out as an Investment Advisor at a Canadian independent asset management firm where he cared for several high-net-worth families. Brett graduated from the University of Calgary with a Bachelor of Commerce degree. He is currently pursuing his CFA designation with the goal of becoming a Portfolio Manager.

Craig Basinger, CFA

Craig Basinger is the Chief Market Strategist at Purpose Investments. With over 25 years of investment experience, Craig combines an educational foundation in economics & psychology with years of experience in both fundamental and quantitative research. A long-term student of the markets, Craig’s thoughts and insights can be seen in his Market Ethos publications and through his regular contributions on BNN.

Craig and his team bring a transparent and cost-efficient approach to investment management. The team provides asset allocation OCIO services and directly manages over $1 billion in assets. The team manages dividend mandates, quantitative risk reduction strategies and asset allocation services.