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Predicting when the next black swan event will take place, and what will cause it, is an impossible task. But that doesn't mean you can't construct a portfolio designed to reduce the risks related to black swans, according to Larry Swedroe and Kevin Grogan, both of whom work at Buckingham Strategic Wealth.

In their latest book, Your Complete Guide to a Successful & Secure Retirement, Swedroe and Grogan present an investment strategy designed to reduce what is often referred to as "left tail risk," a risk they say is increasingly important to those approaching and living in retirement.

Why is that so important?

For one, in retirement, Swedroe and Grogan note in their book, that retirees no longer have the ability to generate income to make up for equity losses; they have less time for markets to recover from bear market losses; and their tolerance for risk tends to decline. And two, they wrote, the order in which investment returns occur increases in importance in retirement. Once retirees begin to withdraw from their portfolios, large losses in the early years of retirement can greatly increase the odds of outliving their assets.

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In a Retirement Daily podcast, Grogan discussed how investors can build an efficient portfolio that reduces the risk of black swans. By way of background, Grogan noted that everything in the book and discussed in the podcast is how Buckingham Strategic Wealth has been building portfolios since its founding back in the mid-1990s.

The idea behind Buckingham's portfolio construction methodology is to use what some people call styles or factors or smart beta. The firm constructs its equity portfolios to tilt towards certain areas of the market that Grogan, Swedroe, et al. think have the potential for higher expected returns. "Essentially the way we think about it at the highest level is that we think there's just certain areas of the market where you can generate higher expected returns," he said.

And two of those areas are large-cap value and small-cap value. "What we've done within our portfolios is tilt or overweight the stock side of those portfolios to small-cap and value stocks," he said.

According to Grogan, tilting the equity portion of a portfolio to those areas will increase the expected return of the portfolio. "But ... the more common way that we've used it over the years is to actually use those tilts to decrease the amount of risk within the portfolio," said Grogan.

How so? He used this hypothetical example: Instead of being 60% in stocks and 40% in bonds, the portfolio would be 40% in stocks tilting towards large- and small-cap value and 60% in bonds. And a "40/60 portfolio that's tilted towards small-cap and value has a similar expected return as that 60/40 portfolio that isn't tilted towards small-cap and value stocks," Grogan said. "And that's really where kind of the science of investing comes in, where we're able to build a portfolio that has the same or similar expected returns but with less risk in terms of volatility and other measures of risk."

According to Grogan, there are two issues to consider when it comes to risk. "It can be difficult to stay disciplined to the plan if the portfolio has more volatility than you're able to handle, and that answer in terms of how much volatility one is able to handle is different for each person that we run across," he said.

The other issue has to do with sequence-of-return risk. "If you have a very high volatility portfolio and you are withdrawing from the portfolio, you can have some risk of sequence-of-returns risk where you're having bad returns early in retirement, which can cause issues down the line," he said.

To be fair, if you have designs on incorporating a factor tilt within your equity portfolio you might need a dose of patience. "I'll be the first to say that that's not for everyone because ... there still can be very long periods where that doesn't work," Grogan said. "So, like the past five years, for example, value has significantly underperformed growth and there have been periods like this in the past, and there will be periods like this in the future, but the key is staying disciplined to the strategy and sticking with it."

Of course, you could use a total stock market approach instead of a factor-based approach. But then you would have to increase the percent of your portfolio invested in equities. "If you want to go with a total stock market approach, I think that those are all - those are perfectly good portfolios as well, but what we would say is that all else being equal, you would have to have more invested in equities if you're going to be total stock market than you would - than if you had a tilted portfolio. So that's sort of the tradeoff that we think about."

The second piece of actionable advice, which, Grogan said, is true whether you consider a factor-tilted portfolio or not, has to do with the fixed-income side of the portfolio. "This is particularly true for retirees, but I think it's useful guidance for any investor," he said. "Try to take most of your risk on the equity side of the portfolio and leave the fixed-income side of the portfolio to be there for capital preservation and for income and to help reduce the volatility of the portfolio."

If you look at Buckingham's portfolios, Grogan said they tend to be very high credit quality, short- to intermediate-term. "We're not taking a lot of risk on that side of the portfolio," he said. "Now again, there are tradeoffs with that as well because that also means that you would have a lower expected return, which you could get in a high yield bond for example."

Grogan also said Buckingham, as part of a process to add unique sources of risk (sources of risk that have a low correlation with each other as well as with stocks and bonds) that also have risk premiums has added four alternative investments to their portfolios. Those investments have equity-like expected returns but with far less volatility and far less downside risk.

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The Investments

Alternative lending: The firm's preferred vehicle is Stone Ridge Asset Management's Alternative Lending Risk Premium fund (LENDX). That fund is essentially buying consumer and small business loans that are originated on platforms such as a Lending Club, SoFi, and Funding Circle, said Grogan. "So, what's appealing about those is they have pretty attractive yields and expected returns," he said. "Of course, you do have some correlation with business cycles with that fund, but that's kind of the appeal of that one."

Reinsurance: The reinsurance industry's existence presents an opportunity for investors to add an asset with equity-like returns that are uncorrelated with the risks and returns of other assets in their portfolios. Their preferred vehicle is Stone Ridge Asset Management's Reinsurance Risk Premium fund (SRRIX).

"Reinsurance gets you exposure to globally diversified reinsurance risks," said Grogan. "So, if it's a really bad year for natural disasters, like it has been unfortunately the past couple years, then you can see negative returns with that fund, but otherwise, you would earn an expected return for investing in that fund. What we like about that one is that there's no real correlation to traditional markets, so the stock market being up or down doesn't cause a hurricane or an earthquake, and for the most part natural disasters don't cause the stock market to decline, so that's what we like about that one."

Variance Risk Premium: VRP refers to the fact that over time, the implied (ex-ante) volatility in options has tended to exceed the realized volatility of the same underlying asset. Their preferred vehicle is Stone Ridge Asset Management's All Asset Variance Risk Premium fund (AVRPX).

The reinsurance fund is providing insurance against natural disasters, while the variance risk premium fund is providing insurance against a spike in volatility, said Grogan. "So essentially it's selling options in the market to sell insurance against future volatility," he said. "And so, again, historically there's very strong academic evidence along these lines that you can collect a premium for selling that insurance, but when you have periods where volatility spikes up as it did towards the back half of last year, you can see negative returns within that strategy as well."

Alternative risk premium: This is a long-short fund which allows investors to capture more of the desired factor premium. For taxable accounts, consider AQR Capital Management's Alternative Risk Premia fund (QRPRX), which provides long-short exposure to six factors, and for tax-advantaged accounts consider AQR's Alternative Style Premia (QSPRX), which provides exposure to four factors and four asset classes.

Given the evidence that value stocks tend to outperform growth stock, AQR is buying a portfolio of value stocks and shorting a portfolio of growth stocks. And you get exposure to the difference: what did value versus growth do. "And they're essentially implementing that across multiple factors and multiple asset classes," said Grogan.

"The goal is for them to outperform, say, fixed income, and then second to have low correlation with stocks and bonds, and that's kind of the two-pronged goal that we have with respect to the alternative allocation," he said.

At Buckingham, he said the allocations to these alternatives ranges between 15% and 25%, equal weighted.

Grogan also said investors should think of their portfolio in terms of probabilities instead of expected returns as deterministic. Given that, he suggests that investors search for Monte Carlo simulation tools or retirement planning Monte Carlo tools and "run at least the more simplistic cases along those lines, and then look at it from that way as opposed to the sort of straight-line methodology where you're assuming you're going to get your expected return every year."

Grogan also spoke to the use and value of Shiller CAPE 10. "The CAPE 10 is one of those metrics that we look at for coming up with our expected return on equities," he said. "And so, I think the way investors should use those metrics is more for planning purposes than for timing purposes."

What about the next black swan event? "So, the nature of black swans is that they're unpredictable," Grogan said. "So, it makes it hard to predict when it will happen and then where it will come from ... I think kind of reality is that no one, you know, really knows where the next big risk will come from."

Grogan's final thoughts: With respect to investment strategy, focus on:

  1. The cost that you're paying for your investment management fees. Try to stick to low-cost fund managers if you can.
  2. Being highly diversified is very important. Don't just own U.S. stocks; own stocks from across the globe.
  3. Consider a tilt towards small-cap and value stocks.
  4. Stick to high credit quality and safe fixed income.

Got questions about money, retirement and/or investments? Email Robert.Powell@TheStreet.com