Wednesday, August 6, 2008

Take More Risk to Cover Losses?

Yesterday's NY Times story reports that the NY State Comptroller is worried about two stresses on the state pension fund - more state workers are retiring as the baby boomer cohort gets to their 60s, and the fund took a 6.4 percent loss on its domestic equity investments. The fund fell by $600 million in nominal dollars for an overall 2.6 percent return (after adjustment for payouts), which is well below the 8 percent return that is built into the pension fund's projections. The NY State fiscal year ends March 31, so the equity loss was before the steep drop in June.

The bright spots in the Comptroller's report are high reported returns of 24.8 percent in private equity and a 14.8 percent return in real estate. The Comptroller is asking the State Legislature to let him raise his bets in this area, the riskier "alternative investments" that also include commodities and hedge funds. Comptroller Thomas P. DiNapoli is now allowed to invest 25 percent of the state pension fund assets in these riskier areas - an increase of 10 percentage points was agreed to by the Legislature in 2006.

DiNapoli is essentially saying that the 8 percent target will be hard to meet in traditional debt and equity investments and is saying that he will need to take more risk.

But there are two problems with raising the allocation again:

1. Alternative investments are notoriously less liquid and are harder to value than listed equities.
2. As yesterday's NY Sun notes, alternative investments "increase opportunities for investment managers to make politically motivated decisions," because lobbying can be fierce over these types of investments, both by managers of alternative investments and beneficiaries of the investments.

In considering the request to raise the allocation, the Legislature might pay heed to investment adviser Daniel R. Solin, who describes as a dumb money move "Taking Extra Risk With Your Investments to Make Up for Recent Losses." He says: "Many investors are tempted to take more risk with their portfolios to make up for their losses. This is a bad idea. The fact that you may have lost money in the current markets does not mean that you are able to take more risk. In fact, it may mean the opposite: Your ability to withstand market losses has diminished." More on Dumb Money Move No. 11.