Twenty years ago I entered my first multi-day motorcycle endurance competition.  It began and ended in Columbus Ohio.  I had entered this event without any previous knowledge of what it would take to ride a motorcycle for five days in a row averaging a little over 1,000 miles per day.  Looking back, I should have sought some advice from a few experienced endurance riders.  Instead, I just jumped on my trusty Kawasaki Concours with a stack of AAA road maps and headed to Ohio. 

One of the experiences I have always valued from my motorcycle trips is getting to visit with people from all walks of life.  For most of my trips, I make sure I have time to sit and visit without the pressure of a schedule.  And if my destination is work-related, I get the added benefit of a tax deduction.  For this trip, though I was heading to Ohio for a motorcycle competition, I thought I might be able to incorporate a little work to help offset some of the travel cost.

So I thought of whom in Columbus Ohio I could visit with to add to my knowledge and qualify the trip as a business expense.  At the time we owned shares of BankOne, who for the majority of its history was headquartered in Columbus.  But alas, they had moved to Chicago a year before. There was another option, however, that could potentially combine a little business with my trip. Of the many individuals who have influenced our approach to portfolio management, one that stands out is Robert H. Jeffrey, head of the Jeffrey Company.  The Jeffrey family sold their manufacturing business in 1974, and with the proceeds of the sale turned the company into an investment vehicle operating out of Columbus.

I first discovered Mr. Jeffrey when I came across an article, published in the Fall 1984 edition of The Journal of Portfolio Management, titled “A New Paradigm for Portfolio Risk.”  A short summary of this paper provided by the Jeffrey Company is as follows:  “Risk is a function of the cash-flow relationship between a portfolio’s assets and its liabilities, i.e., it’s the probability of not having sufficient cash with which to buy or retire something important.”

There have been many new approaches to portfolio management.  As all professional advisors should, I take the time to explore these new approaches.  Yet it seems that each new approach is simply a minor change to the long-standing acceptance that risk is the volatility of current asset prices.  By concentrating on short-term asset prices, not long-term results, the individual investor can easily make those major mistakes that earn you membership into the buy high, sell low club. 

Over the past ten years, since the last great crash in asset prices, the financial academics and professional portfolio managers have not budged from their almost universal acceptance of risk, yet individuals seem to have another view.  A recent AICPA survey of 631 CPA financial planners stated that nearly one-third (30%) of their clients’ top retirement fears is running out of money.  This fear is being compounded by the fact that people are living longer, with many more years of retirement having to be funded without earning a paycheck.  With this in mind, I want to share the full summary of Mr. Jeffrey’s paper which has helped us tremendously in the management of retirement and endowment funds.

Summary:  The Need for Cash Drives the Process

In the last analysis, risk is the likelihood of having insufficient cash with which to make essential payments.  While the traditional proxy for risk, volatility of returns, does reflect the probable variability of the cash conversion value of a portfolio owner’s assets, it says nothing about the cash requirements of his liabilities, or future obligations.  Since fund assets exist solely to service these cash obligations, which vary widely from one fund to another in terms of magnitude, timing, essentiality, and predictability, portfolio owners are being seriously misled when they define risk solely in terms of the asset side of the equation.

            Specifically, since both history and theory demonstrate that diversified portfolio returns historically and theoretically increase as return volatility increases, owners should be explicitly encouraged to determine in their own particular situations the maximum amount of return volatility that can be tolerated, given their own respective future needs for cash.  While the theoreticians are presumably correct in directly relating volatility and returns, it is the owner’s future need for cash that determines how much volatility he can tolerate and, therefore, the level of portfolio return that can theoretically be achieved.

            My intention in emphasizing the need for cash has been purposely to shift responsibility for the risk-determination process from the asset manager to the portfolio owner.  As one author reminds us, “Spending decisions (and thus future needs for cash) are the one input to the portfolio management equation that is totally controllable by the owner.” Furthermore, the cumulative effect of the owner’s prior spending decisions on future needs for cash can, in most cases, best be fathomed and thus planned for, conceivably modified, and insured against, within the owner’s own shop and not by an outside agent.

            Finally, by letting the need for cash drive the portfolio management process, the owner can make future spending decisions more wisely.  Over time, he can develop and sustain an understandable and defendable asset mix policy that will provide him with an optimum portfolio return given his particular cash requirement situation.  In one sentence, the traditional, narrow definition of portfolio risk based solely on volatility encourages owners to apply a universal risk measurement standard, for which they themselves accept little personal responsibility, to what is essentially a highly parochial problem.

As a professional advisor who builds and maintains portfolios for individual investors, we know that meeting current and future liabilities, even if those future liabilities are unknown, should be the primary driver of portfolio construction. 

I wish I could end this by saying that I spent some time with Mr. Jeffrey twenty years ago when I made that trip to Columbus.  But it never took place.  Sadly, Mr. Jeffrey died at the age of 86 in February of 2016.