Wednesday, July 8, 2009

Goals-based asset allocation: Part B

Using the right tool for the job is fundamental in many disciplines. To drive a nail one needs a hammer, to insert a screw, a screwdriver, to screw unsuspecting investors , Goldman Sachs ( But I digress! Actually, from the viewpoint of many investors, all advisors, not just the ones at GS were guilty last year.

"If your only tool is a hammer, every problem looks like a nail." I love that phrase and it applies well to the investment business. Investment advisors too often believe that making as much money as possible is everyone's goal all of the time. Is that equally the case for a 26 year old investment banker and a 68 year old retired school teacher? Maybe, but not likely. So why do advisors push similar solutions for each client?

Whoa! You may argue that giving the retiree a conservative balanced or all fixed income portfolio and the banker an all equities or emerging markets portfolio is providing different solutions. But neither solution was likely constructed based upon that investor's needs only their perceived risk tolerance. What's the difference? Sometimes not much, but usually quite a bit!

If you ask a prospective investor to mentally divide their pool of investment capital into three buckets:
1. Basic needs: food clothing and shelter
2. Enhanced lifestyle: cottage, vacations, French rather than Chilean wine
3. Legacy: grandchildren's education, philanthropy.
a typical split may be 1.(60%) 2.(25%) 3.(15%).

Now assign risks to each bucket.
Bucket 1 is pretty important so you can't take much risk with that one. Perhaps you buy all bonds with this portion.
Bucket 2 gives you more flexibility. Perhaps a 60% equity 40% bond portfolio will address this need.
Bucket three is a long time horizon goal so perhaps 80% equities and 20% bonds works for this piece.

Now you have addressed client goals but investing time horizon needs to be accommodated. More on this in the next installment.

Thursday, July 2, 2009

Goals-based asset allocation: Part A

There is not much new in the world of asset allocation despite the drubbing portfolios sustained last year. The best and the brightest minds and the most researched and supported techniques failed to save Humpty Dumpty from shattering on impact as he fell from that wall.

The Harvard and Yale Endowments, and in Canada, the Ontario Teachers' Pension Plan and le Caisse de depot et placements with extensive risk budgeting tools and an enviable record of success, succumbed to the same gap in the system that eliminated 30-40% of the value of stock portfolios globally. Capital markets went into "rectal lock" and values plummeted in the ensuing vacuum.

What were the goals of these institutions? Did they achieve what they set out to achieve? What could have been done differently? All these questions are being asked and the industry, its observers and consultants have been offering opinions. The "finger pointing" has been extraordinary. The only question that is meaningful for most of us is: what can investors and investment professionals learn from this experience?

Asset allocation describes the strategy investors follow to divide their money between different assets like stocks, bonds and cash. The underlying principle is that the prices of different assets move in different (uncorrelated) ways leading to the idea that "diversification" protects against risk, as defined as volatility.

The obvious problem is that this approach says little about the objectives of the investor. Volatility is an abstract concept for most retail investors. After the extreme volatility of capital markets last year, I suspect it is a more distant concept for many professionals also.

Goals-based asset allocation attempts to match the volatility of a group of assets to the broad goals of an investor. I'll explore how to do this in future posts.