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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This brief is based on the belief that no one solution can always be in the best interest of everyone.
Although very few people will disagree with this belief, generic solutions still proliferate. The “one size fits all” solutions are popular not because they are best for the investor but because they are easy. The “one size fits all” solution is easy because it does not involve any understanding of the needs or issues that an individual faces or require any action to address those needs and issues.
Target Date Funds (“TDF”) are a marginal improvement over the “one size fits all” solution by recognizing differences in age. In other words, one size fits “everyone born in the same decade”. This one dimension ignores the fact that after considering income, responsibilities, lifestyle, ambitions, health and other key factors, everyone is different.
There are severe consequences for a long term misalignment caused by a generic investment solution such as Target Date Funds. These consequences include:
Fortunately, a simple solution is available that is tailored to an individual’s needs and circumstances. This approach requires only that the investor estimate their personal spending needs for the succeeding five years! In return for this effort, an average investor stands to gain millions of dollars over a lifetime without taking risks with their personal wellbeing.
This simple low cost solution liberates funds that are captured in the low yielding component of the TDF and serves no useful purpose. The low yielding TDF component disadvantages the investor because it:
This solution is the Prudent Asset Allocation strategy that preserves assets that are needed in the short term and prudently invests long term assets for maximum growth.
The great majority of TDF investors landed there because their employer chose that option for them. This was easy for the employer who need not educate employees. This was easy for the employee who did not need to learn about investing.
Employees have been paying a high price for this easy road. The available alternatives were complex and expensive so it was the best course, until now! PAA is simple and low cost but does require attention to maintain the optimum balance of the investor’s spending with income and assets.
The transition from TDF to PAA requires that a PAA Worksheet is prepared to determine what adjustments are necessary to fund short term needs. The PAA Worksheet calculates a forecast and shows what assets need to be transferred between the Preservative and Growth components.
After funds are transferred it is time to select appropriate investments for Preservative and Growth Components. Insured deposits, income guaranteed investments, money market funds or short term treasury securities may be used for the Preservative component. Changes are necessary if assets are not in one or more suitable types.
On the other hand, all TDF assets and future contributions are directed into one or more growth or aggressive growth funds.
The great advantage of TDF’s is the ease of use, particularly when used in conjunction with automatic enrollment in a 401(k) or similar plan. The ease of the TDF for brief periods is advantageous but continued use over extended periods can be very costly. What follows are examples of how TDF’s can be disadvantageous over the long term.
TDFs have a prescribed glide path of allocations to growth investments based only on the investor’s age. This means that as much as 40% of the investor’s holdings are excluded from the high return component for the investor’s entire life. The effect of this practice was tested for an investor employed for 45 years and retired for 30 more:
|
|
Median Value of $1,000 Invested |
Median Return % for Period |
|
TDF (Treasuries & S&P 500) |
$1,936,847 |
193,585% |
|
PAA (S&P 500) |
$2,258,210 |
225,721% |
|
Difference |
$321,362 |
32,136% |
The tests for shorter periods showed proportionally lower returns. For example, in the shortest period tested (employment for 20 years and no retirement) $1,000 invested using TDFs had a median value of $5,054 compared to the PAA median value of $8,231.
Allocations to low yielding investments are intended to protect investors by preventing severe losses, limiting volatility and for the availability of cash to meet short term needs. Allocations to low yielding investments were examined in these three respects.
While paper losses[1] can appear at any time, real losses are incurred only when there is a withdrawal. Losses are best avoided by avoiding withdrawals during market downturns. Using the S&P 500 as the measure, there has always been a recovery after a paper loss. Low yielding investments in TDFs, therefore, serve no purpose in preventing severe losses.
Volatility is unsettling for investors who extrapolate market swings as trends that could remain in perpetuity. Hypothetically, such extrapolation can be prevented by an allocation to low yielding investments. There is yet to be any evidence to support this hypothesis.
Good investment practice is to have funds available for unexpected expenditures. TDFs fail to provide cash availability in two ways:
It has also been argued that TDFs are less stressful to investors. While this is demonstrably true, it is also provable that the low stress is based on a lack of understanding of TDFs. If investors were to realize that the TDF is a packaging of investments available to them based on nothing more than their age, the stress levels would immediately return.
The root of stress is the unknown future and unpreparedness for what might occur. Relief from this stress can be more effectively relieved by a clear presentation of past events and the probabilities of recovery.
There is no consideration for the investor’s personal situation with a TDF. There is no regard for income, liabilities, wealth, obligations, responsibilities, emergencies, children, family or other important considerations.
The situations change over the investor’s lifetime and investment considerations should change to be properly aligned.
As retirement approaches, a major concern for many investors is whether future events will exhaust retirement savings. TDFs offer no solutions to this possibility.
The alternative of PAA does include annual forecasting of cash requirements and a calculation of the long term investment required for the future. Changes in situation and investment value are constantly being updated to give an early warning if it becomes necessary to reduce expenses or change lifestyle.
[1] Paper losses refer to temporary market declines during which the investor takes no action and therefore avoids a real loss. With paper losses, investments regain their value when the market recovers.