Developing a Total Asset Allocation Strategy

So, for example, typically you're investing to hit a target. It might be retirement, the purchase of multiple homes, or some other reason. You want to understand and have crystallized in your mind what's your desired rate of return requirement, as well as appreciation and yield, which are two different things. What's your risk tolerance? What's your time horizon? And then, based upon those, an allocation model can be constructed that hits those attributes at the least risk to you. Not no risk, but the least risk. All of this can then be measured. What then happens thereafter is on a quarterly basis. The portfolio that was designed is tested against your original investment policy objectives. Those are the attributes I described at the beginning of the discussion, and you were able to monitor the success of the portfolio quarter over quarter, year over year, with the ability to make changes. You might shorten your time horizon, you might want a higher yield, you might want greater appreciation. You might find that your expected fund balance may decrease or it might increase. You can make all of those adjustments along the way. So it's a process. And you didn't hear us mention anything about a specific investment return or a specific asset allocation class. That's because that's designed based upon the investors total objectives and risk.
DP: Speaking of those asset classes, what are some of the primary asset classes that are found in most personal portfolios?
TS: Large cap, fixed income, certainly an element of cash. A small cap is popular, although I'll say that small cap has basically underperformed as have global allocations—although those are two additional asset classes. Oftentimes, you'll find mid-cap and, by the way, domestic and international components, too. There's probably some additional asset classes that might include precious metals, real estate, hedge funds, private equity and other alternative asset classes, but I think those in the main probably represent the majority.
DP: What are the most important concerns investors should take into consideration when they either build or review their asset allocation strategy, and by that I mean items like risk tolerance, income needs and asset growth expectations.
TS:This is just our view, it would be risk tolerance. Many investors do not understand why risk is such an important consideration. You might be able to define a rate of return. Remember appreciation in yield. You might be able to know the date by which you would need a particular fund balance. You might even know the amount, but if you don't understand the risk that you're undertaking to attain those objectives that I just discussed, then you're at risk of leaving yourself exposed to non-success. Not attaining the fund balance goal, that's the easiest one. Or perhaps having an allocation that gives you too much risk or volatility at the wrong time. Perhaps the forecasted date that your fund balance is needed, you might have underperformed because the allocation might've been too aggressive. The question I like to ask to measure someone's risk tolerance and to educate them at the same time is, “If you had invested yesterday using the approach that I've just discussed and you were down 20% today, how would you feel?” Knowing that you might have 10 years more to go, some people might focus on the fact they lost 20%, not understanding that they still have 10 years to make up that detriment to get appreciation. Others might say, I'm fine because I do understand that a 20% decline the day after I invested was predicted. It was known, based upon the portfolio construction, that in any given moment this could occur. But on the other hand, there also could have been, maybe not within a day but over another timeframe, a 35% appreciation. I'm somewhat simplifying this, but it's a very good question to start the discussion with.
DP: It all begins and ends with risk. How important is it to review the composition of a portfolio, and how often should the allocations be reviewed?
TS:We employ a process where we review quarterly. Other investment advisory firms might use something more or less frequently. We believe quarterly is sufficient as far as making a change to a portfolio that's a function of what the investment policy statement mandates. Now, remember, we spoke about another discussion that the investment policy statement sites the rate of return an investor is seeking, the amount of risk that can be measured they're seeking, the diversity of assets being invested in large cap, mid-cap, private equity and others, and their investment horizon in a desired a fund balance at the end of such investment horizon. There's more, but that's what we’re measuring this against. If you have deviations beyond what was cited in the IPS, for instance, at a loss in value greater than what was in a range, then that would be a time to look at the portfolio managers and determine are they really investing per the investment policy statement? Are they doing their job? If not, why not? You might go a second quarter before you make a decision, but again, the IPS would also tell you under what scenarios should the investment manager be replaced. That's a discipline. So that's how that process would work, and it really causes the investor to be engaged. Understanding and involvement are good things.
DP: Tim, thanks for that insight. Stay tuned for our next EisnerAmper podcast when we’ll get down to business.