Rethinking Risk

Professors identify new ways to evaluate retirement portfolio risk

by Judy McNally

Financial risk comes in many guises, as anyone following the news lately can’t help noticing. Most investors think of risk in terms of market volatility, and stark reminders of this reality are everywhere today.

Nevertheless, if you plan to save toward an eventual comfortable retirement, you might do well to consider the work of two Lewis & Clark social scientists. Harry Schleef and Robert Eisinger, whose work focuses on a different kind of risk, have been bucking conventional investment wisdom and catching the attention of financial columnists and consultants from coast to coast.

Schleef and Eisinger weighed the kind of advice investors often hear, considered the popularity of so-called life-cycle or target-date funds, and ran some numbers. In fact, they ran a lot of numbers, and came up with surprising results.

Their hypothetical investor, 35-year-old Sally, wants to retire at 65 with $1 million (in today’s dollars). She could start by putting $11,000 a year into a life-cycle fund that would gradually move assets from equity to fixed-income mutual funds over time. That fits with the common advice that one should invest more conservatively as one ages.

But what if Sally were to choose a simple formula like 80 percent stocks and 20 percent bonds, and keep that proportion constant as she continued to invest over the entire 30 years? It turns out that statistically, assuming historical rates of return, she would be more likely to reach her million-dollar goal (see graph).

Given the volatility of the equities market, such an allocation would require a strong constitution–and never more so than now. However, the pair, who share academic interests in quantitative methods, statistics, decision making, and attitudes toward risk, note that this work broadens the concept of investment risk beyond the usual consideration of market volatility–to include the risk of failing to meet one’s investment goals. As Eisinger explains, “We’re complementing the volatility risk with the succeed/fail risk.”

To explore how different portfolio allocations are likely to play out, Schleef uses a Monte Carlo simulation program that randomly chooses periods of years from the past and repeats the process 1,000 times. His model adjusts for inflation: Sally’s target nest egg would need to be much larger than $1 million to attain spending power equivalent to that amount in today’s dollars. Schleef rebalances the hypothetical portfolios at the end of each year to keep the allocations constant. A necessary underlying assumption is that the stock market will continue to perform statistically as it did from 1926 to 2006.

Last fall, Schleef and Eisinger published their results in a paper, “Hitting or missing the retirement target: comparing contribution and asset allocation schemes of simulated portfolios,” in the academic journal Financial Services Review. This year, their findings reached a more general audience through columns by financial writers Mark Hulbert in the New York Times and Gail Buckner in the online FOXBusiness publication. Eisinger and Schleef also coauthored a piece in Investment News, which publishes online and in print.

Such media attention doesn’t come along every day for most social scientists, but the focus of their work interests many people–more every year, as the U.S. population ages. Schleef says, “Though our results were against conventional wisdom, we’re not outliers, and other research supports our findings.” Eisinger picks up, “What we uncovered bucks the trend in three ways: Historically, high equity exposure has not been a bad thing. Life-cycle funds have done no better than steady 80/20 exposure. And the probability of failing to achieve $1 million remains high no matter what strategy you pursue.” And, they point out, choosing a simple allocation like theirs could improve the investor’s outcome by avoiding fees charged by life-cycle funds.

In some ways, Schleef’s and Eisinger’s contrasting backgrounds and temperaments might not make them the obvious pair to undertake this work. Schleef’s route to the economics department ran through Lewis & Clark’s now-discontinued business and administrative studies program. He has taught, done research, and consulted on management, corporate finance, statistics, investments, and the like. His relaxed, friendly manner tends to put others at ease. Eisinger, an intense, straight-speaking New Yorker, usually focuses his academic interests on American politics, political parties, presidential polling, and media bias. He is a familiar Portland voice as a political analyst, formerly for KPAM radio, now with Oregon Public Broadcasting.

Eisinger is also the more likely to ask the provocative questions, such as, “I looked at the popularity of the life-cycle funds and asked myself, ‘Do I buy it?’” Aware of Schleef’s previous work in analyzing retirement portfolios, he would emerge from his office, two doors from Schleef’s, and strike up hallway conversations about the questions on his mind. Thus, in recent years, the two have shaped the work together.

In addition to convenient offices and their shared interest in risk–and in maximizing their own retirement portfolios–the colleagues both earned their PhDs at the University of Chicago, almost 20 years apart. They seem to complement each other’s work styles and clearly enjoy their collaboration, exchanging easy banter and almost finishing each other’s sentences as they discuss their favorite topic. They look forward to pursuing other aspects of the subject, including what would happen with international funds in the mix, and creative ways to manage one’s portfolio in retirement.

If friends or relatives ask them for investment advice, the usual caveats apply. “I am not a certified financial planner,” intones Schleef. “My parents are my only clients,” says Eisinger. But, he continues, “We do hope savvy financial planners will read our work and take it into account, that the pros will be better informed about decisions and about risk.”

For more details about Schleef and Eisinger’s research, and for links to the publications mentioned, please see www.lclark.edu/faculty/schleef.

Judy McNally edits and writes at McNally Editorial in Portland.