Prudent Asset Allocation (“PAA”) is an overarching investment strategy that separates investors assets into two channels and manages the movement from one to the other in a way that maximizes the safety of the first channel and maximizes return in the second. In this way investors earn as much as is feasible without putting their wellbeing at risk.
The first channel is called the Preservative component and contains assets needed to fund present and short term future expenditures. Assets in the Preservative component are allocated to each of the next five years and used to fund ongoing expenses, planned purchases, emergencies and other spending in those years.
In the event that the Preservative component for one year is exhausted, “loans” can be taken from succeeding years. In this way, unexpected situations are immediately covered and the “loans” repaid by withdrawals from the Growth component when market conditions are favorable.
The Preservative component uses payment instruments and investments that can be converted into payment instruments with no penalties or delays.
The second channel is called the Growth component and maximizes investment return on assets that will not be needed in the short term. When the planned need to use the Growth component is within five years, a gradual shift is begun into the Conservative component.
The Growth component is invested in a diversified portfolio that can reasonably be expected to appreciate in value over the time until the assets are needed. Historical data shows that the worst broad equity markets (S&P 500) recover within five years. Investors can expect that unfavorable markets could last that long.
While highly speculative investments are not advised, there are no restrictions as to the types of assets that can be used. The keys to Growth investment selection are:
The key benefits of PAA are:
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In this brief we examine the two real risks that investors face and the ways in which these real risks are mitigated by the design of PAA. The first is running out of funds and the second is needing funds during unfavorable market conditions. While the discussion of risks has a multitude of facets, they can all be reduced to these two real risks. By managing the real risks, investors are properly protected.
The risk of running out of funds is created by overspending. This is controlled by anticipating expenditures and future funds, then dialing back planned expenditures until the threat of overspending is eliminated. The funds available in future years must exceed the usage funds to ensure that the risk of running out is mitigated. This is the first priority of PAA and is the reason for establishing a Protective component for needed funds. The Protective component is insulated from market risks by retaining these assets in accessible holdings that are stable or guaranteed.
The risk of needing funds when investments have lost value is more difficult to control since there are several possible causes and the time and magnitude are impossible to accurately predict. Causes include life events, added responsibilities, unplanned expenditures, loss of income, market declines, failed ventures, inflation, other changes in the economy, etc.
It is necessary to take the risk of needing the funds at an inopportune time to realize the healthy returns of investing. PAA mitigates the risk on needing funds in three important ways:
Losses that occur at times when the funds are not needed (paper losses) may cause emotional stress but these have proven historically to be temporary. The temporary losses are only harmful if the investor reacts by withdrawing funds after paper losses, thus making them permanent losses.
PAA is designed to delay the need for cash for up to five years, thus allowing the market conditions to become more favorable before a withdrawal is made.
The PAA strategy starts the protection of funds that will be needed in the next five years and prudent but aggressive investing of funds that will not be needed in the short term. In this way, the greatest risks are neutralized while all remaining funds are left to produce returns at the maximum rate.
Market history since 1940 shows the following risks and returns for the Growth component (illustrated by S&P 500) and Protective component (illustrated by US Treasuries):
|
|
Maximum One Year Loss Since 1940 |
Value of $1,000 Invested in 1940 |
|
Preservative Component |
(11.1%) |
$55,019 |
|
Growth Component |
(36.6%) |
$6,336,701 |
By holding assets in two categories (Preservative and Growth), the PAA investor is prepared for the four possible market conditions that can occur at any point in time. These conditions, the frequency of occurrence and PAA responses are:
|
|
Frequency of Occurrence |
PAA Response |
|
Both Growth and Protective Up |
61% |
Protective component has marginal gains. Growth component obtains full benefit of appreciation. Action: Transfer funds as needed to cover future expenditures. |
|
Both Growth and Protective Down |
4% |
Paper losses of Protective component is far less than Growth. Action: Delay any transfer from Growth until market recovers. |
|
Growth Up & Protective Down |
18% |
Protective component suffers marginal losses. Growth component obtains full benefit of appreciation. Action: Transfer funds as needed to cover future expenditures |
|
Growth Down & Protective Up |
17% |
Protective component has marginal gains. Growth component suffers paper losses. Action: Delay any transfer from Growth until market recovers. |
The fact that both Growth and Protective components generally move in the same direction1 shows that holding one does not offer protection against the other.
It is evident from the analysis of the four possible conditions (above), the most likely outcome for any given year is that both Protective and Growth components (61%) are up. This is a favorable condition to make a withdrawal.
The unfavorable conditions for withdrawal are the far less frequent years when Growth is down and Protective is up (17%). If a transfer from Growth is indicated under these circumstances, it should be delayed until the value is recovered.
It is essential that there is a high level of confidence in the accessibility and stability of the Preservative component. This confidence is achieved by using a combination of secure holdings such as bank deposits, US Treasury securities, annuities with guarantees, money market and stable value funds.
Obtain and complete the PAA Worksheet to determine what action is required immediately. Review and revise the PAA Worksheet annually and when significant events occur.
The PAA Worksheet may be obtained from an advisor or directly from DALBAR here.
PAA provides a framework to maximize the investments that produce the highest returns but only after taking care of commitments, expenses and emergencies.