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Strategic Asset Allocation for Individual Investors

Strategic asset allocation is pivotal in executing investment plans. In developing strategic asset allocation, investors establish and specify their desired exposures systematic risk. Groups of assets of the same type are theoretically homogeneous in reflecting a certain set of systematic factors, and different groups of assets have different exposures to factors. The process integrates their financial objectives, risk tolerance, and investment constraints with their long-term capital market expectations.

What Factors Affect Individual Investors’ Strategic Asset Allocation?

First, unlike tax-exempt institutions such like endowments, foundations, and pension plans, individual investors are taxable so they must consider the eventual tax consequences of the investments and the length of holding period, as opposed to simply evaluating expected risk and return characteristics of investment alternatives. Taxation of capital gains and income introduces enormous complexity into individual investors’ investment planning and decisions.

In the United States, many individual investors seek to reduce the tax impact on investment returns utilizing tax-deferred investment vehicles, such as Individual Retirement Accounts (IRAs), 401(k) accounts, 403(b) accounts, Keogh accounts, Simplified Employee Pension (SEP) accounts, and annuities.

Second, individual investors’ investment philosophy is rooted in the fact that they shoulder the responsibility to fund a comfortable retirement. Across the board, the decline in employer-sponsored defined benefit plans (DBP) and the growth in the self-directed segment of defined contribution plans (DCP) has led individual investors to pursue investment options that are more active while riskier. However, most individual investors lack the specialized knowledge necessary to succeed in today’s highly competitive investment markets; less-than-appropriate asset-allocation guidelines have caused a list of investment errors and worse-than-expected investment results.

Another distinguishing characteristic of managing individual investor portfolios lies in the so-called heterogeneity. Individual investors have diverse investment objectives, time horizons, perceptions of risk, and preferences that influence their decision-making process.

Considerations in Individual Investors’ Strategic Asset Allocation

The asset allocation planning for individual investors must account for the part of wealth flowing from current employment-based income to future sources of cash flows, and the changing mix of investment gains and employment-based income as individuals approach retirement. Beyond that, such strategic asset allocation must consider any correlation of employment-based income and investment returns. Furthermore, strategic asset allocation for individual investors should factor in the possibility of outliving their resources, a.k.a. longevity risk, to some extent, although longevity risk cannot be completely managed through asset allocation.

Earning ability is the major condition in determining an investor’s capacity for risk. Individuals with high earning ability can logically take more risk because they can more readily recover from any losses. An appropriate strategic asset allocation for individual investors must take their age and life cycle into account, and such framework and the assumptions about their risk aversion must change with their life cycle and the cash flow patterns of their income.

The book Strategic Asset Allocation: Portfolio Choice for Long-Term Investors by John Y. Campbell and Luis M. Viceira makes three very important points, which have served as the foundation for many strategic asset allocation framework for individual investors:

  1. Investors with stable and predictable employment-based income will invest more of their financial assets into equity-oriented asset classes.
  2. Investors with employment-based income that is highly positively correlated with stock markets are better off choosing an asset allocation framework with less exposure to equity-oriented asset classes.
  3. An investor’s ability to adjust how long and how much he or she works tends to increase the optimal asset allocation to equity-oriented asset classes.

Everything else being equal, as an investor ages, the strategic allocation to equity-oriented assets should decrease. In the effort to implement the plan effectively, investment advisers should take the fiduciary to educate and assist their clients to adopt a life-cycle-related asset allocation strategy.

Moreover, in developing an appropriate strategic asset allocation, investors should determine whether their employment-based income is risk-free or risky, and whether the risk of this source of cash flow is significantly correlated with the stock market. If it has a high correlation with stock market returns, investors should reduce the exposure to risky assets and increase the allocation to the financial assets that are less correlated with the stock market.

It is worth noting that longevity risk is an important consideration in the asset-allocation decision for individual investors. Longevity risk is independent of financial market risk, and investors bear longevity risk directly. Unfortunately, longevity risk cannot be fully managed through asset allocation; an endeavor could be to take additional investment risk in order to earn higher long-term returns given the investor can take additional risk.

For investment advisers, when presenting strategic asset allocation recommendation to clients, it is essential to introduce all the options that are appropriate for the particular client, although most standard asset allocation templates only include stocks, bonds, and cash. Second, investment advisers should make sure that the asset classes they recommend are indeed best choices for the particular investor from the perspectives of tax efficiency and transaction costs. Finally, when choosing a time horizon for risk and return presentation, investment advisers should refer the respective client’s financial objectives and unique circumstances.


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