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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