The goals-based approach to asset allocation is useful for individual investors, who typically have a number of (sometimes conflicting) objectives, with different time horizons and different levels of urgency, which we will measure as specified required probabilities of success.
In this approach:
- The investor’s portfolio is composed of subportfolios, and each investment goal is addressed individually with these subportfolios.
- Taxable and tax-exempt investments are part of the opportunity set.
- Instead of expressing an investment goal as an expected average return on the portfolio, we identify and document “minimum expectations” for each goal, which is the minimum expected return necessary to provide a specified minimum required probability of success over the given time horizon.
Often, the advisor will select from a set of preestablished subportfolios (modules) to meet specific goals of a client rather than create new subportfolios for each client. The modules are distinguished by differences in risk-return tradeoffs, liquidity requirements, and the inclusion or exclusion of certain asset classes.
The asset allocation is determined by identifying, for each goal, the module that provides the highest expected return with the specified probability of success over the required time horizon. Then the size of the investment in that module is simply the present value of the future goal discounted at the expected return of that module. The portfolio allocation is then the sum of all of the individual investments necessary to achieve each goal.
Characteristics of the Three Liability-Relative Asset Allocation Approaches
| Surplus Optimization | Hedging/Return-Seeking Portfolios | Integrated Asset–Liability Portfolios |
|---|---|---|
| Simplicity | Simplicity | Increased complexity |
| Linear correlation | Linear or non-linear correlation | Linear or non-linear correlation |
| All levels of risk | Conservative level of risk | All levels of risk |
| Any funded ratio | Positive funded ratio for basic approach | Any funded ratio |
| Single period | Single period | Multiple periods |
Other Approaches to Asset Allocation
120 Minus Your Age
It relates your age to your allocation to equities so that 120 − age = % allocation to equities, with the remainder going to fixed incomes.
It’s consistent with the idea that as the value of human capital declines as we age, our capacity to bear risk in the rest of the portfolio declines, suggesting that we move from equities into fixed incomes
60/40 Split
You simply maintain your asset allocation at 60% stocks and 40% bonds.
Endowment Model or Yale Model
Under this approach, you allocate larger amounts to alternative investment asset classes (private equity, real estate, or natural resources) than is typically recommended by a strict MVO. Presumably these markets are less-than-perfectly informationally efficient, so investment managers with expertise in these markets can outperform expectations. Also, they are less liquid, and certain institutional investors are positioned to take on additional liquidity risk in return for a liquidity premium because of their longer time horizons. The approach is popular with university endowment funds.
Risk Parity
The idea with the risk parity asset allocation approach is that diversification is achieved by ensuring that each asset class contributes the same amount to the total portfolio risk. This addresses critique 4 of MVO that diversification across asset classes does not guarantee diversification across risk sources. The criticism of this approach is that it ignores expected returns and focuses only on risk.
1/N Rule
If we create an equally weighted portfolio in which we allocate the same percentage to each asset class, we have in effect weighted each class by 1/N, where N is the number of classes.
One common method is to rebalance to equally weighted each quarter. Although it sounds very simple, there is some empirical evidence that this type of approach actually performs better than we would expect.