Risk and reward in investing are often defined in terms of the nominal dollar value of the portfolio: dollar gains, dollar losses, dollar volatility, dollar value at risk, etc.
But these are only indirectly related to the actual goals of individual or institutional investors. Might it be better to focus explicitly on investor goals over an investment horizon and manage assets accordingly? We believe in this increasingly popular approach and propose the following 4×4 super-structure for goals-based investing.
Assets and liabilities in any portfolio should contribute to:
- Liquidity Maintenance: having a nominally safe and quickly accessible “cash-like” pool of assets. Cash reserves cushion portfolios in crises and serve as stores of “dry powder” to potentially buy depreciated assets during fire sales.
- Income Generation: relatively regular, certain, and near-term cash payments, such as coupons, dividends, and systematic tax-managed appreciated asset sales proceeds.
- Preservation of (Real) Capital: assets should retain their real value over time, despite the uncertain future outlook for inflation. Commercial and residential real estate, commodity-related assets, and collectibles, for example, may contribute to this goal.
- Growth: more volatile assets and strategies that are expected to generate higher future cash payments. Most private and (growth) public equities, as well as cryptoassets, and other “moonshot” investments — in option-speak, think of these as deep-out-of-the-money calls — should help accomplish this.
In a balanced and diversified portfolio, all four goals should be “powered.” This is why we’ve dubbed our strategy 4×4.
Four Investment Goals, Time Horizons, and Cash Flow Characteristics
How can we implement these concepts in practice in an investor-specific way?
First, we start with the investor’s preferences, expressed by three variables.
- T is the strategic investment horizon over which the investor seeks to achieve their goals, say five, 10, or 30 years; an age-dependent horizon; or even “forever.”
- τ is the tactical rebalancing / trading frequency, for example, a day, a month, or a quarter.
- B is the “substantial loss” barrier: What kind of drawdown will the investor be comfortable with? The loss barrier can be mapped to the risk-aversion parameter using a power utility function. For example, for a more risk-seeking investor, the loss of B=15% of their net worth could imply the same loss-of-power utility as the loss of B=3% for a more risk-averse investor.
Next, we determine, based on the investor preferences, how much each asset contributes to each of the four goals. We propose the following approach in 4×4 Asset Allocation:
For every asset / liability we distinguish between “return of capital” cash flows — final sale / disposal / maturity of the asset — and “return on capital” cash flows, or coupons, dividends, real estate rent, futures “roll return,” FX “carry,” royalties, systematic tax-managed sales of appreciated assets, labor-related income, etc. While this distinction may seem artificial and ambiguous, we believe the implications for liquidity, transaction costs, taxes, accounting, and ultimately re-allocation decisions are important enough to warrant separate consideration of these two cash flow types.
Then we separate the “return of capital” cash flows into two buckets: liquidity and preservation. Heuristically, liquidity is quickly and easily accessible and the less volatile part of the cash flows, while preservation — in particular, inflation protection — is powered by potentially more volatile investments that are expected to retain their real value if held for longer periods.
We also divide the “return on capital” cash flows into income and growth. For us, income is the nearer and surer part of the return on capital flows, and growth is the more distant and volatile aspect of the return on capital flows.
To formalize and quantify this intuition, we apply option pricing theory. Every asset / liability is mapped to four “virtual portfolios”: Liquidity, Income, Preservation, and Growth based on the investor’s preferences. Every asset / liability contributes to — or detracts from — the four goal areas in an investor-specific way.
For illustrative purposes, imagine a high net worth individual with the strategic horizon T=10 years and a certain schematic portfolio allocation derived from two sets of preferences. The first is more risk-seeking and risk-tolerant with tactical rebalancing frequency 1 year and the “substantial loss” barrier B=15%, and the second is more risk-averse with tactical rebalancing frequency 1/52 years, or one week, and the “substantial loss” barrier of B=3%.
Based on these preferences, the very same portfolio maps differently to the four goals.
Examples of 4×4 Decomposition
Further, we propose advanced portfolio construction techniques to build investor-specific strategic and tactically rebalanced 4×4-optimal portfolios.
Strategic Investment Horizon T and Tactical Rebalancing Frequency τ
Investors that focus solely on the nominal asset dollar prices often neglect one or more of the four goal categories. Even asset-rich individuals and institutions can suffer cash flow or liquidity problems, especially in turbulent market conditions. This can lead to asset fire sales at depressed prices. Other investors may be too risk-averse and miss out on opportunities to grow their assets or protect against inflation. Still others can be prone to myopia and fail to balance their strategic and tactical goals and risks in a disciplined fashion.
With explicit strategic portfolios, rebalanced at tactical frequency to re-align with strategic goals and take advantage of short-term opportunities, our 4×4 Asset Allocation is a framework well suited for constructing a truly balanced and diversified portfolio.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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