Understanding Asset Allocation Linking investment risk with your desired future

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1 Linking investment risk with your desired future Copyright 2011 All Rights Reserved Version 1.0

2 General Advice Warning The material contained in this ebook is for general purposes only and should not be used as a substitute for personal financial advice. The ebook was prepared without taking into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material.

3 Linking investment risk with your desired future Chapter 1: Introduction 1 Chapter 2: What is asset allocation and why is it important? 2 Chapter 3: Choosing your target asset allocation 6 Chapter 4: Measuring your current asset allocation 9 Chapter 5: Transitioning to your target asset allocation 13 Chapter 6: Summary and conclusions 17 Chapter 7: About Wealth Foundations 18

4 Introduction 1. Introduction Our objective is to help clients become financially well organised and make smart financial choices so they have the best chance of enjoying the financial future they want. A key to achieving this objective is agreeing an appropriate investment risk exposure with each client and carefully managing that exposure over time. This risk exposure is most appropriately measured by the client s asset allocation. This ebook provides an overview of our approach to asset allocation. Most people think they have a pretty good idea of what asset allocation is all about. Our experience suggests they don t. While we start off pretty basically, we hope that by the end you will agree that by viewing asset allocation in the lifelong context we advocate some conventional financial planning views are challenged and some smarter ways of thinking about personal finance issues emerge. The next chapter answers the questions What is asset allocation? and Why is it important?. The following three chapters then discuss, in turn: 1. What is the right investment risk exposure for you i.e. your target asset allocation?; 2. What is the appropriate way to measure your asset allocation? and 3. How do you move from where you are now to your target asset allocation? Together, they build gradually to introduce and explain the use of our Projected Lifetime Investment Wealth framework, that uniquely and explicitly links your lifestyle expectations to your desired level of long term (or lifetime) investment risk. Wealth Foundations Page 1 Phone:

5 What is asset allocation and why is it important? 2. What is asset allocation and why is it important? What is asset allocation? At the highest level, your asset allocation is the division of your investment wealth between defensive assets and growth assets. Defensive assets are low risk, low expected return investments like cash and fixed interest. Growth assets are higher risk, higher expected return investments like domestic and international shares and property. We view your asset allocation as the most fundamental measure of your investment risk exposure. The higher your allocation to defensive assets, the less variability there will be in the range of future wealth possibilities. But this lower variability comes at the expense of expected (but not guaranteed) lower investment returns. A 70% defensive/30% growth investment portfolio is expected to have considerably less variability but lower returns than a 30% defensive/70% growth portfolio. Return differences between defensive assets are primarily driven by exposure to credit and maturity or term risk i.e. the better the credit risk (i.e. ability to repay) and the shorter the term to maturity (i.e. when repayment is due) the lower the expected return. Our view is that the purpose of holding defensive assets is to reliably reduce the overall volatility of your investment portfolio, rather than deliver high returns. We don t actively encourage clients to pursue extra returns by opting for higher credit risk or long maturities as the premiums have not, in the past, justified the often considerable additional risk. If higher returns are required, the growth asset classes of shares and property offer higher expected returns for their higher risk. Research suggests that the returns of share portfolios will be driven by what happens to the overall share market, plus their tilts to what are called the size factor (i.e. small versus large shares) and the price factor (value versus growth shares). For a more complete explanation of how investment returns are linked to well documented risk factors, see Risk and return are related. We have purposely excluded investment offerings such as commodity funds, private equity funds and hedge funds from the above discussion of growth asset classes. They are not generally considered part of our asset class universe for a combination of reasons that include: an inadequate or unclear source of expected return for risk taken; a lack of cost effective diversification; and high fees and expenses, that are not reliably linked to expected returns. Wealth Foundations Page 2 Phone:

6 What is asset allocation and why is it important? Why is asset allocation important? On the assumption that your investment portfolio is well structured (i.e. low cost, highly diversified both across and within selected asset classes, tax aware), your mix between defensive and growth assets will be the primary driver of both: Your expected investment returns; and, more importantly; The variability in your investment wealth at any time in the future. Research has shown that attempts to enhance investment returns through share selection (i.e. stock picking) or switching between asset classes based on forecasts of expected returns (i.e. market timing) have not added value and, on average, cannot. To examine the link between asset allocation and future wealth possibilities, let s consider the following 70% defensive/30% growth ( Defensive Portfolio ) and 30% defensive/70% growth ( Growth Portfolio ) portfolios: Defensive and Growth Portfolios US Based Data (December 1969 December 2010) Defensive Portfolio Allocation (%) Growth Portfolio Allocation (%) US Treasury Notes US Long Term Government Bonds Total Defensive S&P 500 (i.e. Large US Shares) MSCI EAFE (i.e. Large International Shares) Total Growth After inflation return (% p.a.) Volatility(% p.a.) Over the period from December 1969-December 2010, the Defensive Portfolio returned 3.8% p.a. after inflation, with volatility of 6.6% p.a. This means that in any year there was a 68% chance that the actual return could vary by ±6.6% from the average i.e. between -2.8% and 10.4%. The Growth Portfolio returned 4.9% p.a., with volatility of 10.9%, suggesting a 68% chance that returns could vary between -6.0% and 15.8%. Wealth Foundations Page 3 Phone:

7 What is asset allocation and why is it important? With the benefit of hindsight, the Growth Portfolio provided the highest return, but the higher volatility suggests considerably wider variation in annual returns than for the Defensive Portfolio. If we assume that in future the portfolios have the same expected (but not guaranteed) returns as the historical returns and the same volatilities, we can simulate potential growth of wealth paths for any period based on an initial investment. The charts below show the range of possible wealth accumulation for an initial $10,000 investment over a 30 year period for both the Defensive Portfolio and the Growth Portfolio, based on 10,000 simulations: Features to note include: The range of possibilities for the Defensive Portfolio are considerably narrower than for the Growth Portfolio, reflecting the increased certainty that comes with lower volatility; The middle, average and 90 th percentile for the Growth Portfolio are higher for than for the Defensive Portfolio, driven by the higher expected return; and For downside situations, represented by the 5 th percentile, the Defensive Portfolio is less susceptible to the investment falling below its initial value and results in higher wealth after 30 years than for the Growth Portfolio. Lower variability and downside protection come at the expense of foregoing potentially higher long term wealth. Wealth Foundations Page 4 Phone:

8 What is asset allocation and why is it important? But how do you choose the right asset allocation for you Having briefly explained what asset allocation is and its importance, the next chapter considers how to choose the right asset allocation for you. While the choice is a mixture of both art and science, we believe that the ability to adhere to a disciplined investment strategy is highly dependent on understanding the basis for the choice and then committing to it. Wealth Foundations Page 5 Phone:

9 Choosing your target asset allocation 3. Choosing your target asset allocation The determinants of your asset allocation choice In the previous chapter, we focused on the questions What is asset allocation? and Why is it important?. In this chapter, we provide an overview of what is most important when choosing your target asset allocation or investment risk exposure. At the highest level, we measure risk exposure by how your investment wealth is divided between defensive (low risk) and growth (higher risk) investment assets. In The asset allocation decision we explained that your mix between defensive and growth assets should be determined after a careful weighing up of the following sometimes competing considerations: Your appetite or attitude to risk - sometimes called your risk tolerance ; Your need for risk - the level of risk you need to take to give the best chance of achieving your financial objectives; and Your capacity for risk - your ability to recover from adverse investment outcomes. We refer you to that previous article for a fuller discussion of each of the above decision inputs. However, as discussed below, investor behaviour during the Global Financial Crisis has since caused us to both refine the concept of a target asset allocation and the priority we give to the above decision inputs in making the asset allocation decision. Traditional thinking on asset allocation The traditional view on asset allocation tends to be that young adults can afford to take more investment risk since they have time to recover should initial investment performance prove to be poor and/or their personal circumstances not evolve as originally projected. Consequently, the advice is that they should hold heavily growth oriented investment portfolios. Wealth Foundations Page 6 Phone:

10 Choosing your target asset allocation However, as investors approach retirement they have less time to recover from adverse investment markets, and the suggestion is they should progressively reduce their allocation to growth assets (and investment risk). By retirement, they should achieve a mix of defensive and growth assets that they intend to maintain for the rest of their lives. This thinking underpins target date funds that are hugely popular in the US and becoming more so in Australia. The fund manager reduces the allocation to growth assets to a target level that varies solely with the investor s age or expected years to retirement. The approach implies that there are a number of age dependent asset allocation targets. In our opinion, this traditional view and target date funds, in particular, are seriously flawed. Other than the investor s age or retirement expectations, no account is taken of individual circumstances and lifestyle expectations. For example, some 45 year olds may have already maximised their income earning potential in their field of employment (e.g. teachers, some investment bankers and business executives) while others have their best earning years ahead of them (e.g. medical specialists, partners in law and accounting firms). It is unlikely that they should have the same target asset allocation, despite being the same age or years to intended retirement. And, as discussed in the following chapter, Measuring your asset allocation, the simplistic way asset allocation is traditionally measured means that the difference between your current pre-retirement asset allocation and a desired retirement target asset allocation provides little guidance as to how you should transition from where you are now to where you want to be. There is only one target asset allocation So, what do we think your target asset allocation should be. Our view is that there should be only one target. Your maximum target growth exposure should be no greater than your attitude to risk will allow you to live with (i.e. to sleep well, no matter what investment markets are doing) once you are relying solely on your investment wealth to meet all future expenditure. This generally coincides with retirement. Unless your attitude to risk changes 1, your target is unlikely to vary with age. As we will explain in our next article, most young accumulators will not be anywhere near their target asset allocation. Generally, given the way we measure investment wealth, they will be significantly overweight defensive assets. Their challenge is to choose an investment strategy that is designed to achieve their target by retirement (and/or financial independence), with the best chance of meeting (or exceeding) their lifestyle expectations. 1 Research has indicated that attitude to risk does not change greatly over time for individuals. However, perceptions of risk can vary considerably and are often driven by investor sentiment. The aim is to improve your understanding of your perception of risk and to avoid reacting to it. Wealth Foundations Page 7 Phone:

11 Choosing your target asset allocation Why do we place so much emphasis on attitude to risk in setting your target asset allocation? It is largely driven by our observation that during the Global Financial Crisis many of those who were carrying more growth assets than consistent with their risk appetite abandoned their investment strategy, even though it may have been consistent with their assessed need and capacity for risk. If your emotions don t let you stick with a well conceived strategy when times are tough you give up a clear decision making approach for one based on how you feel. From a financial perspective, making investment decisions with your heart, not your head is unlikely to be successful over the long term. From the viewpoint of your psychological wellbeing, it will almost certainly be a disaster. We therefore maintain that your attitude to risk should set the upper bound for your target growth asset exposure. In the next chapter we will elaborate on the above discussion when we explain how you should measure your current asset allocation. Wealth Foundations Page 8 Phone:

12 Measuring your current asset allocation 4. Measuring your current asset allocation You need to know your current asset allocation In the previous chapter, we discussed the key determinants of the choice of your target asset allocation. But in developing an investment strategy designed to reach your target by retirement it is essential to have a meaningful measure of your current asset allocation. For those who expect to continue to accumulate wealth from business or employment earnings, the traditional ways of measuring asset allocation are not very helpful. A better approach to asset allocation takes advantage of our Projected Lifetime Investment Wealth framework. It takes a much broader view of wealth and provides valuable insights relevant to answering many typical personal finance questions e.g. how much could or should I borrow, how should I build my risky growth asset exposure over time, can I afford a larger home. To illustrate our approach, let s consider Stephen, a 40 year medical specialist who wishes to retire at age 65. His family s current balance sheet is shown below: Assets ($ 000) Liabilities ($ 000) Residence (L*) 2,500 Mortgage 1,000 Cars, Furniture (L) 200 Bank Accounts (D**) 50 Practice Rooms (G***) 400 Investment Loan 200 Superannuation: - Defensive Assets (D) - Growth Assets (G) Shares (G) 150 Total Assets 3,700 Total Liabilities 1,200 NET WORTH 2,500 *L=Lifestyle Assets, **D=Defensive Investment Assets, ***G=Growth Investment Assets Stephen and his family have a net worth of $2.5 million. But what is their current investment asset allocation? Wealth Foundations Page 9 Phone:

13 Measuring your current asset allocation An asset allocation hierarchy A first consideration when measuring asset allocation is whether to include lifestyle assets (e.g. residence, cars etc) in the analysis. Stephen has made it clear that he never wants to be in a position to sell lifestyle assets to fund living expenses. Accordingly, they are ignored as investment assets. The basic and most common way of measuring asset allocation is to look only at investment assets. The table below shows Stephen s asset allocation on this basis. Asset Based ($ 000) % Defensive Growth Total 1, A reasonably high growth position of 75.0% is suggested. The conventional view would be that this is not inappropriate given his relatively young age and 25 year earning expectation. However, the total investment assets of $1.0 million are not a measure of the funds available to Stephen and his family to live off if Stephen is no longer working. They must be reduced by outstanding debt. Borrowings are, effectively, a negative defensive asset. We call the difference between investment assets and borrowings Net Investment Wealth. Its importance is discussed in our Blog article, How far to financial freedom. The calculation of Stephen s Net Investment Wealth ( NIW ) is shown below: Asset Based ($ 000) % Net Investment Wealth ( NIW ) ($ 000) % Defensive n.a. Growth n.a. Total 1, n.a. A negative NIW implies that all of Stephen s net worth is tied up in lifestyle assets. Remember, the current residence is never to be used to fund living expenses. On this basis, Stephen has not even started accumulating for retirement! Wealth Foundations Page 10 Phone:

14 Measuring your current asset allocation But we also don t think NIW is a true reflection of Stephen s total investment wealth for asset allocation purposes. Based on well considered cash flow projections, Stephen expects to be able to save (and invest) at least $3.75 million in today s dollars between now and his age 65, or an average of $150,000 p.a. This Projected Surplus Capital (or Future Capital ) is, in our view, as much a part of Stephen s wealth as conventional investments like cash, shares and property. Until actually saved and invested, we regard it as a defensive asset (after appropriate adjustments for various uncertainties). On this basis, total defensive assets are now $2.8 million i.e. projected surplus capital of $3.75 million plus actual net defensive assets of -$0.95million. The chart below shows the allocation of Stephen s Projected Lifetime Investment Wealth, that includes future capital: Asset Based ($ 000) % Net Investment Wealth ($ 000) % Projected Lifetime Investment Wealth ($ 000) % Defensive n.a. 2, Growth n.a Total 1, n.a. 3, It reveals that Stephen s current asset allocation is 79% defensive / 21% growth, an apparently fairly defensive position. It suggests an entirely different view of his risk exposure than the simplistic Asset Based asset allocation measure. The Projected Lifetime Investment Wealth approach puts the level of Stephen s current growth asset holdings into context. While they may appear large relative to his current investment assets, when compared with the funds expected to be available for investment in the future they are modest. Projected Lifetime Investment Wealth drives your investment strategy It is this asset allocation based on Projected Lifetime Investment Wealth that needs to be compared with Stephen s target asset allocation (i.e. the mix between defensive and growth assets that Stephen will be comfortable holding when he is no longer working) when formulating an appropriate investment strategy. If we assume that Stephen s target asset allocation is 40% defensive / 60% growth, the chart below reveals the discrepancy between his current growth asset allocation (of 21.1%) and the target growth asset allocation target (of 60%). Wealth Foundations Page 11 Phone:

15 Measuring your current asset allocation Stephen s investment strategy should focus on how he wants to transition from his current growth asset allocation to the target growth asset allocation over the next twenty five years. The issue of transition is the subject of the next chapter. Wealth Foundations Page 12 Phone:

16 Transitioning to your target asset allocation 5. Transitioning to your target asset allocation How do you close the gap between your current and target asset allocation? The previous chapter explained how we believe wealth accumulators (those whose after-tax earnings exceed their lifestyle expenditure) should measure their current asset allocation. It requires them to estimate their projected surplus or future capital to add to their Net Investment Wealth, to calculate a measure of total Projected Lifetime Investment Wealth. This future capital is regarded as a component of defensive asset holdings, with the upshot being that those with many years of expected accumulation ahead of them may be considerably underweight growth assets compared with their target growth asset allocation. In Chapter 4, we looked at the example of Stephen, a 40 year old medical specialist, with a current growth allocation of 21% compared with a target at age 65 of 60%, as illustrated in the chart below: Wealth Foundations Page 13 Phone:

17 Transitioning to your target asset allocation This chapter builds on that discussion. It briefly examines a proprietary framework we have developed that would help Stephen choose an appropriate investment strategy to transition from his current 21% growth exposure to 60% growth over the next 25 years. Transitioning to your target asset allocation: by accident or by design? To illustrate the framework, let s consider a couple of investment strategies that accumulators commonly adopt. These were discussed in a previous article, Building your exposure to shares and property. The first strategy is often considered conservative. It involves no serious attempt to build growth exposure until the mortgage has been paid off. Let s assume Stephen initially allocates future savings to paying off his $1 million mortgage. The mortgage is repaid in ten years so that by his age 50, in terms of the methodology discussed in Measuring your current asset allocation, his future capital has reduced by $1 million, as has his debt, leaving his net defensive position unchanged. If the (after inflation) value of growth assets has not changed over this period, the following chart shows Stephen s growth exposure as unchanged over the past ten years. It also reveals what needs to be achieved over the next fifteen years to reach the target of 60% by his age 65. Wealth Foundations Page 14 Phone:

18 Transitioning to your target asset allocation The chart highlights that Stephen s decision to focus initially on repaying his mortgage means that the time available to achieve his growth target has been compressed. And there is the possibility that during the period that future capital was directed to repaying debt, the price of growth assets may have increased substantially implying that future growth exposure will be more expensive to acquire. Of course, the prices of growth assets could have fallen or stayed the same. The second default strategy we see is considered more aggressive. It involves borrowing a relatively large amount of funds (relative to investment wealth) as soon as there is sufficient equity in the family home, and investing these funds in growth assets. The strategy is driven by a desire to reduce tax (through negative gearing) and accelerate wealth accumulation. As an example of this strategy, we assume that at age 41 Stephen borrows a further $1 million and invests the funds in a portfolio of growth assets. Based on our methodology, this results in a shift of $1 million from defensive assets to growth assets. The revised path to the target growth asset allocation is shown below: Borrowing and investing have pushed Stephen s growth exposure to almost 50% at age 41, meaning that in one year he has completed the great bulk of the growth investment necessary to achieve his 60% target by age 65. This will prove a great strategy if the price of growth assets continues to rise over the next 24 years. However, if they fall he has limited capacity to take advantage of the lower prices as much of his future capital will be directed to repaying borrowings. Wealth Foundations Page 15 Phone:

19 Transitioning to your target asset allocation Why wouldn t you spread your growth asset bets over time? Both strategies fail to effectively spread the risk of increasing growth exposure across time. The conservative strategy back-ends the increase in growth exposure while the aggressive strategy brings it forward. Both strategies implicitly and, usually, unwittingly, take timing bets that add to the risk that less than desired long term wealth outcomes will be achieved. Our framework reveals that a lower risk strategy may be to spread the required increase (or decrease) in growth exposure to reach your target evenly over the period between now and the time you wish your target to be achieved. It is represented by the solid red line on the charts above. For Stephen, it would imply increasing his growth allocation by about 1.6% p.a. of Projected Lifetime Investment Wealth for 25 years, spreading his growth bets as broadly as possible. Provided nothing changes, this implies that Stephen should invest $55,000 of savings into growth assets (i.e. 1.6% of $3.55 million) next year. This may mean deferring paying off the mortgage or, perhaps, borrowing tax deductible debt to purchase the growth assets. In practice, our clients do deviate from this default strategy. But they do so with their eyes wide open. A move above the solid red line indicates a deliberate bringing forward of growth exposure, while a move below the line is a deliberate deferral. Wealth Foundations Page 16 Phone:

20 Summary and conclusions 6. Summary and conclusions Hopefully, this ebook has provided you with a few new concepts to consider and food for thought regarding asset allocation. These concepts particularly apply to those who are wealth accumulators. In summary, the key insights we discussed include: There is only one target asset allocation: that which you feel you can live with when you have no or limited future earning capacity and need to rely primarily on your investment wealth to support your lifestyle. Your target growth exposure will be no greater than is consistent with your attitude to investment risk; Borrowings are negative defensive assets, that should be offset against cash and fixed interest holdings to calculate your defensive asset exposure; and A measure of future capital should be explicitly taken into account as part of your investment wealth, both when determining your current asset allocation and deciding on an appropriate investment strategy to transition to your target asset allocation. The Projected Lifetime Investment Wealth framework introduced in Chapters 4 and 5 provides powerful insights into the consideration of a number of personal financial planning issues. Most importantly, it guides the development of an investment strategy that uniquely and explicitly links your lifestyle expectations to your desired level of long term (or lifetime) investment risk. Without the benefit of such an integrated approach, most investment strategies are effectively flying blind, almost certainly involving greater or lesser investment risk over time than intended. Wealth Foundations Page 17 Phone:

21 About Wealth Foundations 7. About Wealth Foundations Wealth Foundations is an independently owned personal financial advisory and wealth management firm. We distinguish ourselves by helping people make smart decisions to better manage their wealth and achieve their desired financial future. Matters relating to money, finance and wealth are highly emotional. Everybody seems to have opinions, usually based on anecdotes rather than evidence. Fear and greed, together with other negative emotions, often drive decisions. There is also a massive product driven industry out there preying on and exploiting those emotions. In addition, an almost unlimited availability of success stories and finance related information in the media masquerades as and is often confused with financial knowledge and wisdom. There is a high level of ignorance regarding what works and what doesn t in the area of personal wealth management, together with an alarming lack of awareness or acknowledgement of that ignorance. Not surprisingly, people often make poor decisions that objectively are not in their best interests. We can help you avoid the common and not so common personal wealth management pitfalls. We help you handle the inevitable emotional pressures and make decisions that our experience and the best available science suggest are most consistent with the life outcomes you want. As a result, not only are you more likely to achieve your financial objectives, but you can devote more of your valuable time and energy to pursuits where you have genuine expertise and/or enjoy. If you would like to take a first step towards: having your personal wealth managed with a level of professionalism that you demand of yourself in your field of expertise; enjoying the peace of mind that comes from knowing that you will be making smart financial decisions to secure the financial future you want for you and your family; and the confidence and assurance that comes from having a committed and capable partner contributing to your wealth management success then call us on to discuss how our service would be of value to you. Please feel free to send this ebook to friends and colleagues. To find out more about our service, visit. For our views on typical financial planning issues sign up for our Smart Decisions blog. Wealth Foundations Page 18 Phone: