INSURANCE COMPANIES are disproportionately represented among the world’s oldest companies. John Hancock was founded in the 1860s. Cigna dates to the 1700s. Some insurers are even older. Why is that?
In my opinion, it’s because they employ a strategy called asset-liability matching. In simple terms, insurers organize their finances so cash is always available when they need it.
Let’s say each winter typically results in $100 million of auto claims for a particular insurer. If you looked at the insurer’s internal books, you’d see $100 million set aside for winter 2022, another $100 million for 2023, and so on. By following this approach, insurers greatly reduce the likelihood they’ll end up in a cash crunch. They do sometimes get caught by surprise, but this technique has been good enough to help many insurers survive for 100 years or more.
That’s why asset-liability matching is such a valuable concept. At its most basic level, it’s what financial planning is all about—ensuring there are sufficient funds to meet financial goals as they arise throughout life. That said, insurance companies have armies of actuaries to manage this process. For an individual, asset-liability matching would be unwieldy to implement. That could explain why the idea doesn’t get a lot of attention outside insurance circles.
Until now. A recent paper, “All Duration Investing” by investment manager Cullen Roche, offers a new perspective on asset-liability matching, one that can be applied more easily to individuals.
Roche starts by building on the concept of duration, an idea typically used only in analyzing bonds. If you aren’t familiar with duration, don’t worry. It’s a notion that author William Bernstein has called “dizzyingly complex.” The easiest way to think about duration: It’s a measure of how long it will take an investor to break even on an investment.
Suppose an investor pays $1,000 for a 30-year bond that will make 5% annual interest payments. How long will it take this investor to break even on his $1,000 investment? He’ll receive $1,000 at maturity in 30 years, of course. But to break even, he won’t need to wait that long, thanks to the 5%—or $50—interest payments he receives each year. Result: This investor will receive his full $1,000 back by the end of the 20th year (20 x $50 = $1,000).
Technically, the duration would be even less than 20 years, but the precise figure isn’t crucial. Instead, the important point here is that duration is a measure of how long it would take an investor to break even. Because of that, investors often use duration to measure the riskiness of bonds. The longer it will take to break even, the riskier the bond.
The expected return on a bond is a relatively simple calculation that can be done at the time of purchase. In the absence of a default, there’s little uncertainty about the return a bond will deliver. That’s in contrast to the expected return on a stock—and most other investments—which can’t be known at the time of purchase.
This is where Roche’s paper takes a useful leap. While acknowledging that the returns from most investments are somewhat unknowable, Roche argues that they can at least be estimated. Using those estimates, investors can calculate duration figures for asset classes other than bonds. This includes stocks, commodities and other asset classes.
By way of example, consider how Roche calculates the duration of the stock market. First, he estimates the potential downside. In line with history, he figures that the stock market could decline 55% in any given year. Then he makes an estimate of the stock market’s potential future return. In his paper, Roche uses a real return—that is, after subtracting the hit from inflation—of 4.65% a year. Putting these two pieces together, Roche calculates a duration for the stock market of approximately 18 years.
Here’s how the math works out: If the stock market were to drop 55%, it would take 18 years to recoup that loss and get to breakeven, assuming you notched 4.65% a year. If that sounds like a long time, I agree. But remember, this is just an estimate. As Roche explains, the goal is simply to help investors determine “how long they can reasonably expect to be underwater in a very bad bear market.”
In reality, the stock market usually delivers above-average returns for a period of years after a steep decline. In 2003, for example, when the market began to recover from the dot-com crash, the S&P 500 rose 29%. Similarly, in 2009, after the worst of the financial crisis had passed, the market gained 26%. Returns like that would get investors to the breakeven point much quicker than 18 years.
The specific figures are less important than the overall concept. The key idea is that investors should attempt to assign some duration estimate to each asset class in their portfolio. That then allows them to think in terms of asset-liability matching. To understand this, let’s look at some examples.
The simplest case is cash in the bank. Because it can be withdrawn at any time at full value, cash has a duration of zero. That’s why cash is ideal for near-term obligations—a mortgage payment next week, for example.
Now, let’s look a little further out on the duration spectrum. A short-term bond might have a duration of three years. If that’s the case, these bonds would be most appropriate for obligations that are a few years out—a future tuition payment, for example.
Even further out on the duration spectrum are intermediate-term bonds, with a duration of around five years. These might be appropriate if you’re working toward buying a home down the road.
Finally, at the outer end of the duration spectrum come long-term bonds, stocks and commodities. These are most appropriate for long-range goals, beyond five or 10 years.
While some estimating is required, this duration approach to investing offers several advantages. First and maybe most important, it provides structure. Google the term “asset allocation,” and you’ll find millions of results. That’s one reason many investors default to the traditional 60% stock-40% bond portfolio. It seems roughly right and, in the absence of a more formal way to arrive at an allocation, it seems like a reasonable choice. The problem, though, is that everyone is different. For that reason, Roche’s duration-based approach strikes me as a better, more personalized way to approach the asset allocation decision.
To be sure, financial planning will always involve some amount of guesswork. If you have young children, they might go to a private college costing $80,000 a year, or they might go to a state school for half that. The same is true of retirement planning. For instance, your expenses will vary based on where you choose to live. It’s unrealistic to attempt formal asset-liability matching in the way that insurance companies practice it. But as the old adage goes, it’s better to be roughly right than precisely wrong.
Roche emphasizes another benefit of this approach: It can help investors contend with the uncertainty of investment markets. When we go through the exercise of assigning a duration to every asset in our portfolio, the result is a better understanding of the role of each investment. Or, to put it another way, we can gain a better understanding of what to expect from each asset.
That can be invaluable during periods of market volatility. Instead of fretting about a decline in stocks or in long-term bonds, we can remind ourselves that these assets have longer durations. Thus, we shouldn’t expect them to bounce back immediately and shouldn’t worry when they don’t. We should instead focus on the expected breakeven point.
Another reason not to worry: If we’ve done our homework, we should have sufficient short-term assets to carry us through until that point.