4×4 Asset Allocation: Four goals over one investment horizon

Risk and return in investing is usually defined by way of the nominal dollar value of the portfolio: dollar gains, dollar losses, dollar volatility, dollar value in danger, etc.

However, these only not directly relate to the actual goals of individual or institutional investors. Would it perhaps be higher to focus explicitly on investor goals over an investment horizon and manage assets accordingly? We consider on this increasingly popular approach and propose the next 4×4 superstructure for goal-oriented investing.

Four goals

Assets and liabilities in any portfolio should contribute to:

1. Maintenance: to have a nominally secure and quickly accessible “cash-like” pool of assets. Cash reserves cushion portfolios in times of crisis and function “dry powder” to purchase up potentially depreciated assets during fire sales.
2. Generation: relatively regular, secure and short-term money payments resembling coupons, dividends and systematic, tax managed, estimated proceeds from asset sales.
3. of (real) capital: Assets should retain their true value over time despite the uncertain future inflation outlook. For example, business and residential real estate, commodity-related assets and collectibles can contribute to this goal.
4. : more volatile assets and methods which are expected to generate higher money payments in the long run. Most private and public (growth) stocks, in addition to cryptoassets and other “moonshot” investments – in options parlance, you possibly can consider these as “deep-out-of-the-money” calls – should help achieve this.

In a balanced and diversified portfolio, all 4 goals must be “driven”. For this reason, we named our strategy 4×4.

Four investment objectives, time horizons and money flow characteristics

How can we put these concepts into practice in an investor-specific way?

First, we start with the investor’s preferences, expressed through three variables.

• is the strategic investment horizon over which the investor wants to attain his goals, for instance five, ten or 30 years; an age-dependent horizon; and even “forever.”
• is the tactical rebalancing / trading frequency, for instance at some point, one month or one quarter.
• The barrier is “significant loss”: what sort of loss will the investor be comfortable with? The loss barrier might be mapped onto the danger aversion parameter using an energy supply function. For example, for a more risk-tolerant investor, losing 15% of their net value could represent the identical lack of energy as losing 3% for a more risk-averse investor.

Next, we determine how much each asset contributes to every of the 4 objectives based on investor preferences. We propose the next approach 4×4 asset division:

For each asset/liability, we distinguish between “return of capital” money flows – final sale/disposal/maturity of the asset – and “return of capital” money flows or coupons, dividends, real estate rentals, futures “roll return”. Foreign exchange carry, royalties, systematic tax-driven sales of valued assets, employment-related income, etc. While this distinction could seem artificial and ambiguous, we consider the implications are for liquidity, transaction costs, taxes, accounting and ultimately allocation decisions vital enough to warrant considering these two sorts of money flow individually.

We then divide the “return on capital” money flows into two areas: liquidity and preservation. Heuristically, the money flow part is quick and simple to access and fewer volatile, while inflation protection is provided particularly by potentially more volatile investments which are expected to retain their real value when held for an extended time period.

We also break down “return on capital” money flows into income and growth. For us, it’s the closer and safer a part of the capital return streams and the more distant and volatile a part of the capital return streams.

To formalize and quantify this intuition, we apply option pricing theory. Each asset/liability is assigned to 4 “virtual portfolios”: Liquidity, Income, Maintenance and Growth, based on the investor’s preferences. Each asset/liability contributes to or detracts from the 4 goal areas in an investor-specific way.

To illustrate, consider a high net value individual with a 10-year strategic horizon and a selected schematic portfolio distribution resulting from two sets of preferences. The first is more risk-on and risk-tolerant, with a tactical rebalancing of years and a “significant loss” barrier of 15%. The second is more risk-averse, with a tactical rebalancing of years or every week and a “significant loss” barrier of three%.

Based on these preferences, the identical portfolio might be mapped in another way to the 4 goals.

Examples of 4×4 decomposition

Additionally, we propose advanced portfolio construction techniques to construct investor-specific, strategic and tactically rebalanced 4×4 optimal portfolios.

Strategic investment horizon and tactical rebalancing frequency

Investors who focus exclusively on nominal dollar asset prices often neglect a number of of the 4 categories of objectives. Even wealthy individuals and institutions can suffer from money flow or liquidity problems, especially in turbulent market conditions. This can lead to fireside sales of assets at low prices. Other investors could also be too risk-averse and miss opportunities to grow their wealth or protect themselves against inflation. Still others could also be vulnerable to short-sightedness and fail to balance their strategic and tactical objectives and risks in a disciplined manner.

With explicit strategic portfolios which are rebalanced at tactical intervals to align with strategic objectives and capitalize on near-term opportunities, our 4×4 Asset Allocation is a framework well suited to constructing a very balanced and diversified portfolio.

If you enjoyed this post, remember to subscribe.

Photo credit: ©Getty Images/Arctic-Images