FREE NEWSLETTER

Money When Needed

Adam M. Grossman

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.

Our Free Newsletter

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.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
14 Comments
Inline Feedbacks
View all comments
Denise Clark
Denise Clark
14 days ago

Actually, come to think of it, this almost sounds more like time segmentation problem than asset – liability matching in a structural way. If that is the case, there seem to be easier ways to practically implement the timing of needed cash. For example, one can implement a rolling bond or CD ladder to match cash needs for the years one is delaying Social Security.

Cullen Roche
Cullen Roche
14 days ago
Reply to  Denise Clark

Hi Denise,

Yes, as the paper notes, you can apply this in as complex a manner as you wish depending on your required ALM needs. For instance, the paper specifically notes that you could use as few as 3 ETFs to accomplish this. Doesn’t get much easier than that!

Thanks for reading.

Denise Clark
Denise Clark
14 days ago

Interesting article, but practically extremely difficult to implement. I think that Wade Pfau has a much more easy to understand and practical way for matching assets to liabilities. Easier to implement as well. He matches reliable income with essential expenses, a diversified portfolio with discretionary expenses/legacy, and reserves for contingencies such as spending shocks. An example of how to implement: Social security, pensions and/or SPIAs matching essential expenses; insurance and a reverse mortgage line of credit used only to cover spending shocks; and a diversified portfolio for discretionary expenses/legacy (that can be more aggressive than otherwise due to the fact that essential expenses and spending shocks are covered). I highly recommend all of his books for detailed explanations as to how this works along with valuable information on what questions to ask in order to implement.

Nick M
Nick M
14 days ago

Applying the concept of duration to equity seems completely unhelpful. Individual investors should make sure they don’t hold an overall bond duration of more than x years (based on their volatility preference), because as we’re seeing today, bond fund prices can swing by as much as 3x their duration. For example, Vanguards VBTLX fund has a 52 week high/low of 11.41/9.58 (19.1%) and a duration of 6.7 years (6.7×3 =20.1%).

But the reason to have a duration preference at all for bonds, is because we expect bonds to have a certain amount of price stability. We can accurately achieve an expected price stability to match our own preference, by simply adjusting the overall bond duration of the portfolio; making bond duration a useful concept.

However, when it comes to stocks, there is no expectation of price stability, and there is no way to accurately tailor the price stability of a portfolio using the concept of stock duration. During the Great Depression stocks lost 90% of their value. The day before that 90% drawdown began, how would knowing a duration value of stocks be at all informative when constructing a portfolio?

In an interview I remember Jack Bogle once said people should consider having about half their bonds intermediate term and half short term. When it comes to duration, that’s probably all anyone needs to know.

Cullen Roche
Cullen Roche
14 days ago
Reply to  Nick M

Hi Nick,

IMO, the value in applying duration to other instruments is that it can put their expected stability into the proper perspective. For instance, in the paper I calculate the “duration” of equities at approximately 18 years. That is a reasonable time period for which one might expect equities to be stable.

That’s one of the essential principles of vague concepts like “stocks for the long run” or “buy and hold” – we know equities are stable over very long periods, but what this does is try to apply an actual time horizon to that concept so that we can construct portfolios where we specifically segment the various assets out over time horizons that match our liabilities across time.

The real value in this form of a “bucketing” strategy is that it improves certainty of specific buckets being there when you need them to be there. For instance, during the Great Depression you would have had specific short duration buckets that offset all the uncertainty of the stock market crash. That allows you to remain fully invested in the equity slice because you know that’s a multi-decade instrument.

Hope that clarifies. Thanks for reading.

Nick M
Nick M
12 days ago
Reply to  Cullen Roche

Maybe that’s why this concept doesn’t land with me, I find no value in bucketing when it comes to portfolio construction.

Last edited 12 days ago by Nick M
isrosenberg
isrosenberg
14 days ago
Reply to  Nick M

It is my understanding that the approximate expected share price change in % for a bond fund is the product of duration in years times the change in yield in %. For this reason I keep the assets I expect to spend down over the next couple of years in cash equivalent and Ultra-Short-Term investment grade bond funds.

Nick M
Nick M
12 days ago
Reply to  isrosenberg

Sounds like a good plan. You are correct regarding duration, though since the change in yield % is completely unknown, even that formula is somewhat unhelpful. How would one actually plan for, say, a 10% unexpected yield change, where “safe” bonds drop by 70%. The yield curve definitely did not forecast the current 3% yield change, and technically there is no limit to how high yields can unexpectedly go.

I think retirement portfolios should always contain a healthy cash (Money Market) and short term bond allocation, possibly even a mini ladder of bonds/CDs maturing when retirement withdrawals are actually scheduled. The future is unknown, and all we can do is diversify.

parkslope
parkslope
16 days ago

While this is an interesting approach to investing, I have doubts about the usefulness of attempting to estimate the duration of equities. A quick search revealed that the notion of equity duration has been around for at least 40 years but does not appear to have gained widespread acceptance.

Equity duration – how viable?This empirical evidence convincingly demonstrates the shortcomings of depending on equity duration as a useful, stable construct, particularly as a metric to measure and manage risk. In this article we will consider the historical attraction of the equity duration concept, discuss why it has turned out not to be particularly viable, and briefly review the academic literature on the topic.
https://www.ipe.com/equity-duration-how-viable/17520.article

Cullen Roche
Cullen Roche
15 days ago
Reply to  parkslope

HI Park,

Thanks for reading. I agree that “duration” as an interest rate sensitivity indicator cannot be cleanly applied to stocks (or other instruments). But that is not how we’re using the concept of “duration” in the paper. We are using “duration” in the scope of an investor’s sensitivity to likelihood of losses across time. In doing so we are creating a bond-like time horizon for the assets that give an investor the proper perspective over which they should judge certain instruments. This creates a “point of indifference” that is very similar to the way a bond is sensitive to interest rates and principal losses.

All in all I agree that any such concept ends up with hypotheticals and a fair amount of guesswork, but from a behavioral perspective I believe there is great value in assigning a general time horizon to assets that do not have clarity on time horizons.

I hope that helps!

parkslope
parkslope
15 days ago
Reply to  Cullen Roche

Thanks for the clarification. However, Adam went to some length in this article to link the commonly used notion of the duration of bonds to your approach, which is misleading if you aren’t using “duration” in the traditional sense. In order to avoid the impression that you are using duration as it is commonly used in finance, I suggest that you a different term.

Last edited 15 days ago by parkslope
Cullen Roche
Cullen Roche
15 days ago
Reply to  parkslope

I thought Adam did a nice job explaining that we used the term in the same manner that Bernstein did over 20 years ago:

There are lots of other definitions of duration, some dizzyingly complex, but “point of indifference” is the simplest and most intuitive.”

I am sorry if that wasn’t clear.

David Powell
David Powell
16 days ago

Lots of good points here, thanks so much Adam! Roche’s paper is also an interesting read.

Howard Schwartz
Howard Schwartz
17 days ago

This is a good explanation of duration. Just a couple of comments for the nerds. Another useful way to look at duration is as a measure of interest rate sensitivity. If interest rates change, the value of your fixed income securities will change. The longer the duration, the more the value will change. Another important thing to keep in mind is that duration is not linear, it is convex. The calculation involves the coupon rate, current interest rate, call date and maturity date. Mr. Bernstein is correct, duration is complex!

Free Newsletter

SHARE