What is Prudent Asset Allocation?
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.
Prudent Asset Allocation: The Preservative Component
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.
Prudent Asset Allocation: Growth Component
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:
- A robust history of high returns
- Proven ability to recover from declines
- Diversified investments to avoid concentration risk
Prudent Asset Allocation Benefits
The key benefits of PAA are:
- A balance of Preservative and Growth components that is specific to investors current situation.
- Elimination of concerns of making ends meet.
- Elimination of fears of market ups and downs.
- Maximum return on long term assets.
- Continuously adapting to changes in personal situation and investment markets.
- Ability to always wait for market recovery before making withdrawals
Capturing Your Fair Share of Stock Markets
In this brief we show the opportunity cost of failing to take advantage of what is known and instead, acting on what is feared. The result is that millions of investors get out of the market at the wrong times and for the wrong reasons.
The PAA principles described allow investors to take advantage of what is known and overcome irrational fears that lead to underperformance.
Returns for Stocks, Bonds and Cash
Stocks, bonds and cash have earned very different amounts for the investor since the birth of the modern stock market in 1940. This is the year when the final piece of today’s regulatory foundation2 was laid.
If we compute the results of $1,000 invested in 1940, we find the following:
- $4,932,436 for stocks (as indicated by the S&P 500)
- $57,563 for bonds (based on the 10 Year US Treasury Bonds)
- $17,751 for cash (base on US Treasury Bills)
It is evident that $1,000 invested in stocks produced far more favorable results (nearly $5 million). It is also clear that an investor loses an enormous opportunity on funds held in cash ($4,914,685 lost) or bonds ($4,874,873 lost).
It becomes obvious that it is prudent for an investor to keep the largest practical amount of assets in stocks. But since stocks are subject to ups and downs, the investor should protect those assets that will be needed… cash that can be used immediately to make payments and bonds that produce better returns with less volatility.
These findings are the basis for Prudent Asset Allocation (“PAA”).
Why Investors Fail to Maximize Returns
Investors seldom actually earn the maximum potential return from stocks. This is rarely the result of picking the wrong stock. The key reason for investor underperformance is fear. The fear can be rational (I am going to need the money) or irrational (what if I lose it all?).
Rational fear is based on what is most and least likely to occur. Each fear can be categorized based on historical patterns and addressed. Useful categories of historical patterns that indicate likelihood are:
- Pattern is regular and consistent (An example is that diversified investments gain and lose value but gains have always exceeded losses over extended periods).
- Pattern occurs more often than not. (An example is that investors withdraw money after a significant market decline).
- Pattern has occurred in the past but is rare. (An example is that stock investments produce similar results for two consecutive years.
- Pattern has never occurred. (An example is a total loss with a regulated portfolio.)
Irrational fear disregards logic, probabilities and extends as far as the mind can conjure. Irrational fear is the major cause of investment losses.
While PAA contains solutions for rational fear, irrational fear is beyond its scope.
PAA Key Principles
PAA is designed to direct all available assets into the highest earning investments:
- Take no unnecessary risks with needed funds
- Determine and protect only the funds needed to cover expenditures and contingencies
- Ensure that needed funds are accessible
- Never use a fixed allocation for needs that are changing
- Plan for reasonably likely emergencies
- Avoid daily tracking of long term funds
- Maintain flexibility to wait for good conditions before making withdrawals
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.