7
The Wealth Allocation Framework
What does the ideal investment portfolio look like? If you discuss your investments with a financial advisor on a regular basis, the conversation probably centers on the mix of stocks, bonds, and other assets that you own, as well as a variety of statistical measures of risk and return. If the market has moved up recently, perhaps your advisor has suggested rebalancing by selling some stocks and buying bonds. If there’s an expectation that interest rates may rise, your advisor may suggest selling bonds or other fixed-income investments. If a manager or mutual fund is under-performing, your advisor may suggest selling it and buying another that has better performance. The larger context is likely driven by recent performance, with a focus on volatility as the risk measure.
Think about it carefully for a minute. I bet this experience leaves you feeling unsatisfied or, at best, wondering if there isn’t more to the story. The framework for advisory discussions like these is the legacy of modern portfolio theory, first introduced in the now-famous 1952 paper by Harry Markowitz. According to the principles of the theory, there are two key dimensions of risk. The first is volatility (measured by standard deviation in statistical parlance), which describes the amount that the price of a security fluctuates over time. The second is correlation, which quantifies how securities move in relation to each other and helps determine the stability of portfolio returns. “Optimized” portfolios, according to the theory, are based on a combination of securities appropriately sized relative to each other to make some of the risk disappear without sacrificing returns. Many investors know these principles by name: diversification and asset allocation.
Today we are all disciples of Harry Markowitz. When you walk into any financial advisor’s office, the reports presented to you will no doubt feature an “efficient frontier,” a graphic representation of optimized portfolios at various targeted levels of return, and a suggested asset allocation, the latter in pie chart form, which, as we have discussed, tends to anchor your advisory relationship in a misguided quest to beat the market.
The near-universal acceptance of the Markowitz mean-variance framework is reflected in the financial industry’s continuing use of the volatility of returns to define investment risk, despite a variety of obvious shortcomings. For starters, statistics teaches us that variance is a symmetrical risk measure, one that does not distinguish between upside moves and downside moves. A fund manager who has a few upside surprises in his portfolio should surely not be penalized the same way as a manager who ends up owning a few duds!
So why might you be feeling unsatisfied? One reason is that reducing the complexity of risk to a number is fraught with peril, as behavioral psychologists Daniel Kahneman and Amos Tversky have shown. In an editorial aptly entitled “The Myth of Risk Attitudes,” Kahneman points out: “It is common ground in the industry . . . that the task of a financial advisor is to find a portfolio that fits a number: the investor’s ‘attitude to risk.’ My purpose, here, is to suggest that there is no such thing.”
Kahneman goes on to explain:
A central claim of prospect theory is that people are not consistently risk averse. Yes, they are much more sensitive to losses than to gains. But they are also risk seeking, both in their attraction to long shots and in their willingness to gamble when faced with a near-certain loss. To complicate things further, we know that people do not have a global view of their assets. They hold separate mental accounts and are much more willing to gamble from some of the accounts than others. To understand an individual’s complex attitudes toward risk, we must know both the size of the loss that may destabilize them and the amount they are willing to put into play for a chance to achieve large gains.
Perhaps more tangibly, the standard measure of portfolio risk seems to have gotten divorced from the notion of consequences. As private investor Robert Jeffrey insightfully wrote in a 1984 paper, volatility alone is “simply a benign statistical probability.” The true risk of investing, he argued, “is that [a portfolio] might not provide its owner, either during the interim or at some terminal date or both, with the cash he requires to make essential outlays.” Thus what matters is not the volatility of a security, according to Jeffrey, but its price at the time you need to sell it to meet an obligation. Risk is therefore not simply “what happens” in the abstract but rather the impact of what happens—the “event risk”—on your ability to generate cash flow when you need it.
Furthermore, the very concept of “efficient” portfolios is unsatisfactory when applied to the objective of wealth creation. Since risk and return are two sides of the same coin, creating a well-diversified portfolio that seeks to eliminate all of the risk that can be diversified away might not necessarily be a good thing. If you have an information advantage—deep industry knowledge in a particular area, for example—your financial strategy should enable you to leverage this expertise to create wealth, without jeopardizing your living standard. Likewise, if your aspirations include launching a business or pursuing a vocation that is essential to your personal fulfillment and happiness, your wealth management strategy should work to accommodate this objective.
Perhaps most important, the standard implementation of modern portfolio theory seems to inadequately account for the possibility of extreme adverse market moves, which, as we have seen in prior chapters, occur with alarming frequency. The distinction between true “uncertainty” and “risk,” as Markowitz came to define it, is in fact crucial for investors. One of the first scholars to carefully differentiate the two was University of Chicago economics professor Frank Knight, an iconoclast and firm believer in free markets. In his famous 1921 book, Risk, Uncertainty and Profit, Knight described risk as a “known chance” that is “measurable,” and uncertainty, which is “unknowable” and thus “unmeasurable.”
This distinction was further articulated decades later by Benoit Mandelbrot, a brilliant mathematician who is best remembered today for his pioneering work in fractal geometry, the study of unevenly contoured shapes, a discipline that he applied to a variety of subjects, including finance. In a famous paper published in 1963, he argued that the underlying dynamics of financial markets were “unpredictable, wild and woolly” and were thus not amenable to conventional statistical analysis. The volatility of markets is not just hard to measure, he argued, but in fact it is infinite. Financial markets, like floods and hurricanes, are inherently unpredictable. They are not “mildly random but wildly random.”
It would take several decades, a paradigm shifting book, and a cataclysmic market correction for the arguments against traditional statistical optimization models to go mainstream. The credit goes to Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Highly Improbable. The options trader turned literary essayist and philosopher was born in Lebanon, and thus had firsthand experience of risk (of the life-or-death variety) from an early age. As defined by Taleb, a “black swan” event possesses three characteristics. First, the event is rare, an outlier, and by extension not predictable ex ante. Second, the event makes an extreme impact. And third, human nature being what it is, the event appears, in retrospect, to be both explainable and predictable.
Taleb and Mandelbrot make similar but distinct points. Mandelbrot argues against the very idea that we can, through optimization, tune the risk of a portfolio of investments, since market dynamics are uncertain and the variance (or “risk”) is in fact infinite. Taleb argues that big, unexpected events determine history and the course of our lives, often with devastating impact. However, these “black swan” events appear, in retrospect, to be explainable and manageable, and are reinterpreted by self-serving experts as such.
Regardless of your own aspirations, your wealth management strategy and framework for managing risk must accommodate competing and sometimes incompatible objectives. You might wish to launch a business, while also creating a strategy to provide a financial safety net in the event of extreme downside market moves. Such goals may seem impossibly incongruous, but they need not be. As we’ve seen, every individual or family needs a framework that delivers on three principal objectives:
• The certainty of protection from anxiety and poverty, or safety.
• A high probability of maintaining your standard of living, or stability.
• The possibility of achieving upward wealth mobility and creating the potential to meet your aspirations.
These three seemingly straightforward objectives form the foundation of the Wealth Allocation Framework, an approach to managing wealth that combines modern portfolio theory’s teachings on asset allocation and diversification with key insights from behavioral finance. It is, in fact, in Kahneman and Tversky’s seminal paper on Prospect Theory that people’s consideration of probable outcomes (certainty, probability, or possibility) in their decision making was discussed in the context of financial gambles.
Most important, the Wealth Allocation Framework provides a pragmatic, multidimensional approach to managing risk in relation to your goals. In the Wealth Allocation Framework, risk management addresses both quantifiable risk within the Markowitz framework and true uncertainty as defined by Knight and Mandelbrot. This process, called risk allocation, is achieved by creating three distinct risk buckets to support each of the corresponding three key objectives of your wealth management strategy.
The risk buckets, shown in Figure 7.1, can be summarized as follows:
• Personal Risk: You must protect yourself from the anxiety of a dramatic decrease in your standard of living. Thus, you must immunize yourself from personal risk: the devastating impact of not being able to meet your essential cash needs, regardless of the performance of financial markets.
• Market Risk: You must maintain your lifestyle by earning a rate of return in the financial markets that is comparable to the increase in the cost of living. Thus you will probably have to take on market risk. This is the risk, according to Markowitz, that cannot be diversified away through portfolio optimization.
• Aspirational Risk: In order to create the possibility of wealth creation and wealth mobility, or to fulfill your aspirational goals, you may decide to allocate capital to investments or business ventures that involve idiosyncratic risk and the potential for substantial capital gain or loss.
Figure 7.1: The three dimensions of the risk-return trade-off
Because of its diversified nature, the market risk bucket is about statistically quantifiable risk—the focus of Markowitz’s pioneering work. The safety and aspirational portfolios, on the other hand, are about the risk and opportunity of uncertain outcomes, the focus of Knight and Mandelbrot, among others.
In the Wealth Allocation Framework, risk allocation—that is, the allocation of your assets and liabilities among the three risk buckets—is more important than, and in fact must precede, both the selection of assets and the selection of investments and managers.
The Wealth Allocation Framework recognizes that there is no free lunch. Assets that provide safety and have the potential to hold their value in a market crash will not provide high return potential. Therefore, investments allocated to the personal risk bucket will be selected to limit the loss of wealth but will probably yield below-market returns. Allocations to the market risk bucket will provide risk-adjusted market returns, in accordance with the diversification principles of modern portfolio theory. Finally, allocations to the aspirational risk bucket should be selected to yield above-market returns, but they will carry the risk of substantial loss of capital.
In this manner, each of the three core objectives of your wealth management strategy is assigned its own unique risk profile and requires its own carefully constructed portfolio: a safety portfolio consisting of protective assets; a market portfolio with the objective of stability for the long term; and an aspirational portfolio to help you generate wealth to achieve your aspirational goals.
The Wealth Allocation Framework thus builds upon Markowitz’s legacy and incorporates, within a single, unifying framework, all of your assets and liabilities: not only your cash and investment portfolio, which are typically the singular focus of a traditional advisory relationship, but also assets such as your home or a business.
Because the Wealth Allocation Framework shifts the focus from the abstract performance of markets to your goals and corresponding risks, a key step is getting to the right risk allocation: determining how much risk you are currently taking, and how much risk you in fact need to take or mitigate, in order to maximize the probability that you will achieve your investment goals.
Thanks to those easily recognizable pie charts supplied by your financial advisor or brokerage firm, you are no doubt aware of the current or proposed asset allocation of your investment portfolio. But how do you determine your current and proposed risk allocation?
To begin the process, you (with your financial advisor) should construct an approximate snapshot of your current risk allocation. It is a relatively simple but critical process that involves placing all of your assets and liabilities in the appropriate safety, market, or aspirational buckets. Here are a few ground rules:
Assuming you are not overly concentrated in a stock, sector, country, or asset class, most of your liquid investments will likely be allocated to the market bucket.
If, however, an investment provides safety and is thus characterized by below-market risk, then it belongs in the safety bucket and will likely provide below-market returns.
Finally, if an investment has the potential for above-market returns, it must also possess above-market risk, and thus belongs in the aspirational bucket. Any concentrated or leveraged positions also belong in the aspirational bucket.
Although it is not difficult to objectively assess the suitability of different assets and securities for each risk bucket, you must consider both the risk and return profile of the investment and the purpose it serves in your portfolio to determine the appropriate placement. This is why different investors may sometimes place the same security in different buckets: placement depends on how the security is being used in the portfolio. As noted above, the three-bucket Wealth Allocation Framework provides no free lunch. As such, there are only three categories for your assets: low-risk with low return; market risk with market return; and high return potential with high risk. There is, alas, no low-risk, high-return bucket!
Of course, you may come across or already own an asset that has a lot of risk but very little return potential. The solution in most cases is simple: sell it. Similarly, you may be very lucky or smart and conclude that you have an asset with very little risk and a high return potential. But, unless you are truly an expert investor with specialized knowledge, in most cases the best investment advice you can follow with regard to such an asset is to stop fooling yourself.
Working through the liability side of your personal balance sheet is similarly straightforward. All personal liabilities and debt should be allocated to the safety portfolio, where they reduce the size of your personal safety net. The only exceptions—non-recourse loans attached to specific investments—should be placed in the same buckets that hold those particular investments. In similar fashion, these loans will reduce the value of the corresponding asset.
Let’s take a look at the nuances of these risk buckets and the categorization of assets within them.
Safety, or Protective, Bucket. Protecting your living standard means defending against a multitude of potentially devastating events, including the loss of a job, a major health problem, disability, even lawsuits. Catastrophic market crashes or country defaults also present clear and present threats to your personal wealth. But beyond these obvious risks lie more nuanced ones that depend on your lifestyle, life stage, and market conditions. For example, withdrawing a fixed amount of money each year can have adverse consequences in a declining market. Falling markets might also accelerate the risk of outliving your assets. However, if you are at the peak of your earning capacity, you might be able to take on more risk than an individual who is approaching retirement.
Securities that provide some degree of stability or principal protection clearly fall into the safety bucket. These include cash, short-term Treasury bonds, short- and medium-duration Treasury inflation-protected securities (which provide inflation protection in exchange for a lower yield), principal-protected notes, certain types of annuities, and option strategies used for hedging purposes. Additional assets appropriate for the safety bucket include your primary residence, offset by mortgage debt, as we will explore in more detail.
Essentials such as insurance on your home and automobile, as well as catastrophe, disability, and life insurance, often have no intrinsic value, but they, too, are appropriate to include in your safety bucket. Although insurance policies deplete your safety net every year by consuming premiums, their true value will be evident when we introduce scenario analysis (more on that in Chapter 9). The role of insurance, after all, is to protect against low-probability events that would have a devastating impact on your financial picture or that of your dependents.
Finally, your human capital, or earnings potential, offset by any outstanding educational debt, also belongs in the safety bucket.
Market Bucket. Assets typically included in this risk bucket mirror those of a traditional portfolio allocated to stocks and bonds in accordance with modern portfolio theory. Nearly all conventional equity and fixed-income securities fall into the market bucket, as long as they are sized appropriately as part of your diversification strategy. Alternative investments, such as a fund of hedge funds or commodity or real estate funds, may also belong in the market bucket if these investments are held for diversification purposes and the relatively higher fees and transaction costs, liquidity constraints, and manager risks associated with these investments are in some way mitigated or diversified. Fixed-income securities with moderate interest rate or credit risk belong here, too. However, as noted earlier, short-term Treasuries—those with no credit risk and very little risk of capital loss if interest rates rise—should be treated as cash equivalents and thus belong in the safety bucket.
Aspirational Bucket. This bucket is motivated by the observation that sizable wealth creation requires leverage and concentration of specific assets, even if these characteristics are recognized as “inefficient” within the framework of modern portfolio theory. Assets in this bucket are riskier than the market in general and include the possibility of catastrophic failure and loss of principal.
More often than not, investors may have sizable aspirational assets as a consequence of holding company stock and stock options from the company where they work, or by virtue of owning a business. Investors may underestimate the riskiness of these assets because of their familiarity, which can lead to overconfidence and the illusion of control.
Assets that fall into the aspirational bucket include venture capital and early-stage “angel” investments, as well as family-owned businesses that make up a significant portion of an individual’s net worth. In addition, the aspirational bucket includes executive stock options, concentrated stock positions, single-manager hedge funds, leveraged investments in real estate, and opportunistic call option instruments.
The Wealth Allocation Framework is carefully designed to be logical, intuitive, and simple to understand. The key to risk allocation is not only understanding the particular characteristics of your various assets but also thinking carefully about the role they play in your portfolio. In the next chapter, we’ll work through the nuances of integrating major assets into the Wealth Allocation Framework, from your home or a business to gold, hedge funds, and even concentrated stock positions and stock options. We’ll also discuss the right way to think about, and measure, your progress.
Within the Wealth Allocation Framework, this novel exercise in risk and resource management can be illuminating—and surprising.
