The global financial crisis changed strategic asset allocation framework, as investors are more risk conscious and especially mindful of market liquidity and the importance of credit risk in sovereign bond markets, even in developed economies. Determinants of asset allocation decision for long-term institutional investors are generally return factors, volatility factors, risk tolerance (perception of risk), variables of interest (e.g. the covariance between country returns and changes in global portfolio returns), policy rate differentials, destination country GDP growth prospects, rise in country risk, etc.
Unlike institutional investors, individual investors do not have significant resources, technology, expertise to develop strategy and deep analytical work. Although in some cases they may replicate an asset allocation framework designed for institutions, such as pension plan, it is not applicable in most practices.
Markowitz’s Modern Portfolio Theory (1952) states about the benefits of portfolio diversification, even on the asset class level. In fact, a vast majority of investors across the globe do not follow a well-diversified policy. It is interesting to note that there is a remarkable group of people becoming wealthy over the years who had not followed the diversified approach either. To name a few, mortgage investors who invested in single-property real estate, corporate investors who concentrated in low-basis stocks, those who invested human and financial capital and started a small business, etc, and of course, when examining statistics, we should never ignore “survivorship bias.”
Individual investors have different considerations than simply the averages of the market. The conventional framework fails to facilitate the flexibility and accommodate the dual demands for safety and aspiration. On the efficient frontier, personal utility functions are hard to determine due to some flaws: 1) it only works for investors who maintain their lifestyle and meet the financial obligations during the time frame regardless of market conditions; 2) in reality, we do not know what the specific time frame would be. Furthermore, the efficient frontier approach optimizes a portfolio’s outcome at the end of a single predetermined time period.
Ironically, Mr. Market understands risks only at an aggregate level, not at an individual level. Therefore, personal risk, as an additional dimension, must be factored in to construct appropriate portfolios for individual investors. To consider factors such as:
- Cash flow
- Lifecycle stage
- Ability to weather shortfalls
- Event risk
Mr. Chhabra’s study (2004) suggests the “Three Dimensions of Risk,” that three objectives of an “ideal portfolio” lead naturally to a framework with three different dimensions of risk: personal, market, and aspirational.
To mitigate one of the flaws of MPT theory that it only recognizes market risk and seeks to minimize it through optimal asset allocation, the wealth allocation framework identifies these three risk dimensions and seeks to optimize all of them simultaneously. This framework enables constructing appropriate portfolios with all individual investors’ assets, such as their home, mortgage, market investments, and human capital. The most important finding from Mr. Chhabra’s research is, for individual investor, risk allocation should precede asset allocation. Then he furthered and did the following summary:
- Allocations to the personal risk bucket will limit loss of wealth, but will yield below-market returns.
- Allocations to the market risk bucket will provide risk-adjusted market returns (MPT)
- Allocations to the aspirational risk bucket should yield higher-than-market returns, but with the risk of substantial loss of capital.
Implementation of the Wealth Allocation Framework:
Step 1: Gather complete diagnostic information
- Understand lifecycle details
- Determine client goals and priorities
- Assign cash flows and timelines to each goal
- Classify current assets and liabilities
- Include current and future cash flows
- Risk questionnaire to determine client risk factors and person danger zone
Step 2: Perform risk allocation and asset allocation, portfolio construction
- Categorize and evaluate current state
- Make intuitive adjustments
Step 3: Compute probability of achieving goals using
- Scenario analysis
- Monte Carlo simulations
Step 4: Readjust:
- Risk allocation
- Client goals & cash flows
- Asset allocation within each risk bucket
Step 5: Repeat steps 1 to 4 till optimum balance are achieved
Step 6: Check robustness of solution to market and client risk factors
- Market risk factors: crash
- Client risk factors: inflation
Step 7: Implement
Step 8: Review and readjust as needed
A practical approach starts with the crucial inputs, which combine generic and highly personalized data:
- Capital markets assumptions
- Financial asset totals
- Current lifestyle needs
- Anticipated lifestyle inflation
- Life expectancy of principals
- Asset holding structures
Also, the process involves the interaction of two important components. In either case, we must leave room for flexibility:
- Individual sub-portfolios, which are solely driven by clients goals and sized by translating client needs
- Sub-portfolios constructed through modules, which are driven by risk/return profile and designed to match individual goals and integrated with client preferences
The limits of such process often resulted from the selected client preferences, path dependency, and investment reporting complexity.
- Beyond Markowitz: A comprehensive Wealth Allocation Framework for Individual Investors by Ashvin B. Chhabra (2004)
- Lopes & Oden (1999)
- Kahnerman & Tversky (1979)
- Allairs (1953)