The lost world of asset allocation Part 3: Risk Premium Differentials and Liability Frames.

One of the most important determinants of asset allocation is the risk premium on risky investments. 

The lower the risk premium on risky assets the less rationale there is for their inclusion and the longer the time frame of “risky asset risk” that a portfolio will need to manage.  Asset allocation decisions that involve allocating to longer term higher risk growth assets to provide the differential expenditure (income and capital liabilities less portfolio dividend, interest and other income) are about capturing differences in risk premiums.

But this also requires that asset allocation is also framed in terms of units of liabilities as opposed to just units of assets, such that risk management uses size and timing of liabilities as the primary determinant of rebalancing transactions and asset allocation decisions.   The time frame of risk for risky assets is framed likewise in liabilities.

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The lost world of asset allocation–part 2, the liability profile

This post is in response to a recent article by Rob Carrick on “conventional” asset allocation approaches, titled Longer lives, new investing approaches. It commented on asset allocation rules of thumb to give you your equity allocation and bond allocations.

The trouble is these rules of thumb are meaningless in terms of deriving optimal asset allocations.  How you construct a portfolio should depend on a number of things.  One of the most important determinants of of asset allocation is the liability profile, which in layman’s terms is income and capital needs as a % of the portfolio value.

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The lost world of asset allocation: part 1

How you construct a portfolio should depend on your world view of risk and return, your investment discipline, your resources, systems and expertise, how liabilities are met from assets and the way in which withdrawal risks (of which longevity risk is one of many risks) are managed, the risk and return assumptions you use to assess what liabilities a portfolio can meet (in the face of risk) and how an optimal allocation is adjusted for risk aversion and performance preferences.   

But in reality it can be whatever way the wind is blowing and this just does my head in.  At times, you really have to believe that the only thing keeping us humans where we are, are the shoulders of giants, because without these giants the extraneous weight of our ignorance would surely crush us.  

And to the point…….I have been meaning to comment on some of the many articles I have seen recently on “conventional” asset allocation approaches.   A recent article by Rob Carrick, Longer lives, new investing approaches was a mark I could not ignore:

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