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:

The article commented on asset allocation rules of thumb: for example the 100 minus your age, to give you your equity allocation and by deduction your lower risk asset allocation.  New “improvements” to these “widely accepted conventions” include bumping up the starting figure to 120 to get a bigger equity allocation.   Perhaps we could get tall buildings in down town Toronto less tall buildings in Manhattan – that might work but it depends on the numbers.

These conventions arise because advisors do not know how to construct portfolios to meet financial needs over time and select rough guides that effectively abnegate this responsibility.   These heuristics match up in a vague way with other rules of thumb that recommend high equity allocations for young investors and heavy bond allocations for older investors.  But the rules themselves (100/120/110 minus age) mean absolutely nothing at all!  

How you construct a portfolio should really depend on your world view of risk and return, your investment discipline, your resources, systems and expertise, how net liabilities (which means future savings and capital injections must also be considered) 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 and how the optimal allocation is adjusted for risk aversion and performance preferences.  

Oh, and of course, costs, because costs, in some circumstances, can make a conservative well balanced portfolio a higher risk proposal than a bare bones low cost 100% equity allocation.   So while these rudimentary “non sequitur conventions” might have an ambiguous rationale in a zero cost environment, if you have an advisor you have to ask yourself, what are you paying for?  

The less you know of the process, or the less you can resource, the simpler it should become, the lower the cost of the exercise – rules of thumb allocations should cost next to nothing to implement.  But they don’t always.

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