A Best Interest Approach to Asset Allocation

Asset allocation has been practiced in an arbitrary way since the dawn of the Modern Era[1]. While thought to be beneficial, great improvements to current practices are possible. These improvements are critically important for fiduciaries and experts who have the duty to act in investors’ best interest with care, loyalty and diligence.

Benefits of Asset Allocation

Asset Allocation is expected to deliver two benefits to investors:

• Economic: Increase returns by limiting losses at times when funds are needed. The intent is that Asset Allocation will smooth performance so that values are not depressed when funds are needed.
• Emotional: Alleviate the fear of loss that leads to imprudent decisions. The intent is to achieve emotional stability by reducing the shock caused by market volatility.

The investment theories supporting these practices are sound, but the unanswered question is whether desirable outcomes have been produced at a reasonable cost.

Asset Allocation: Arbitrary vs. Prudent

Current asset allocation practices are described here as Arbitrary Asset Allocation (“AAA”). AAA is an investment blend of Growth[2] and Preservative[3] assets that is intended to provide appreciation produced from the Growth component and the protection of the Preservative component.

The challenge has historically been determining what allocation will provide adequate protection with acceptable loss in return that is in the investors’ best interest.

Prudent Asset Allocation (“PAA”), improves on AAA and does not seek an arbitrary allocation but instead protects the assets necessary to fund investor needs. These protected assets are independent of market performance.

The assets to meet investors’ needs have maximum protection and all remaining assets take full advantage of long term market performance. The needs are calculated for a period sufficiently long to avoid the effect of market decline and recovery. (Try the PAA Worksheet AI Calculator)

AAA differs from PAA in several fundamental ways:

• AAA allocations are based on an arbitrary standard, set and changed by the allocator.
  PAA allocations are based on funding the needs of the investor and on changes in those needs.
• AAA sets allocations based on a blended risk tolerance[4], the passage of time, simulations or institutional guidelines. PAA sets allocations based on the markets historical ability to recover from severe declines.
• AAA uses an allocation target for all or each class of investor, regardless of individual needs.
  PAA calculates and protects the needs of each investor.
• AAA locks in low yielding Protective assets at unnecessarily high levels.
  PAA releases unnecessary low yielding assets to be invested in a Growth component.
• AAA seeks to periodically rebalance to the arbitrary allocation.
  PAA changes the allocation as needs are met and when changes occur in the investor’s situation.
• AAA does not have a response to insufficient assets to fund investor needs.
  PAA permits up to 100% of assets to protected.
• AAA cannot maintain a designated allocation as assets are withdrawn to meet investor needs.
  PAA anticipates usage and maintains funds to meet future needs, independent of the allocation percentage.
• AAA cannot adapt to emergencies without disruption of the Growth component.
  PAA permits the investor to borrow from future needs for emergencies without disruption of long term Growth component. Borrowed funds are replenished in a non-disruptive way.
• AAA puts the entire portfolio at risk from low short term persistency.
  PAA relies on greater long term persistency for the Growth component and takes advantage of superior short term consistency for the Preservative component.
• AAA is vulnerable to negative investor experience when the allocated portfolio is compared to benchmarks.
  PAA protects the investor from disappointment by clear delineation of Growth from Protective components.
• AAA does not include consideration of assets held outside of the investment portfolio.
  PAA requires the consideration, evaluation and possible restructuring of Protective assets.

Money Life with Chuck Jaffe interviews Lou Harvey, President of DALBAR on new asset allocation strategy (15:30).

Conclusion

Historically and structurally, the performance of the Preservative component is far more persistent and therefore more predicable than Growth counterparts. This is advantageous to the PAA since the most time-critical Protective asset is less exposed to an unexpected decline in return.

AAA is used in a variety of applications including individual portfolios, balanced funds, target date funds and other blended investments. In all these cases, a blend of Growth and Preservative assets is set without reference to the short term funds available, amount needed, when needed or time required for recovery from a decline. The effect of AAA is that some investors have excessive protection while others are overexposed.

On the other hand, PAA is based on protecting the assets that require protection and permitting the Growth assets to appreciate at the maximum rate. There is no need for rebalancing with PAA since the allocation is based in the funds actually needed by the investor.

[1] The Modern Era is defined as starting in 1940 when the principal securities regulations were in place under the control of the Securities and Exchange Commission and its associated regulators.

[2] Growth investments primarily consists of equity securities, equity mutual funds and other securities, whose primary goal is appreciation.

[3] Preservative investments are typically bonds, bond mutual funds, money market funds, bank deposits, annuities, guaranteed contracts and other investments that are designed to prevent loss.

[4] A blended risk tolerance refers to an individual’s tolerance for financial risk, regardless of the level of dependency on specific funds for specific purposes and the urgency of each purpose.

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