Risk and reward in investing is 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 real objectives of individual or institutional investors. Would it be better to focus explicitly on investors’ goals over an investment horizon and manage assets accordingly? We believe in this increasingly popular approach and offer the following 4×4 superstructure for goal-based investing.
The assets and liabilities of any portfolio should contribute to:
- Liquidity Interview: have a pool of nominally safe and readily accessible “cash-like” assets. Cash reserves cushion portfolios in times of crisis and serve as “dry powder” reserves to potentially buy depreciated assets at sell-offs.
- Income Generation: relatively regular, certain and short-term cash payments, such as coupons, dividends and proceeds from the disposal of assets appreciated and systematic under tax management.
- Preservation capital (real): assets are expected to 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, can contribute to this objective.
- Growth: more volatile assets and strategies that are expected to generate higher future cash payouts. Most private and public (growth) stocks, as well as crypto-assets and other “moonshot” investments – in terms of options, think of them as calls outside of money – should help accomplish that.
In a balanced and diversified portfolio, all four objectives must be “fed”. That’s why we called our strategy 4×4.
Four investment objectives, time horizons and cash flow characteristics
How can we put these concepts into practice in an investor-specific way?
First, we start from the preferences of the investor, expressed by three variables.
- J is the strategic investment horizon over which the investor seeks to achieve his objectives, say five, 10 or 30 years; an age-dependent horizon; or even “forever”.
- τ is the tactical/trading rebalancing frequency, for example, a day, a month or a quarter.
- B is the “substantial loss” barrier: what type of withdrawal will the investor be comfortable with? The loss barrier can be mapped to the risk aversion parameter using an electric utility function. For example, for a more risk-seeking investor, the loss of B= 15% of their net worth could imply the same power loss utility as the loss of B=3% for a more risk averse investor.
Then, we determine, based on investor preferences, how much each asset contributes to each of the four goals. We propose the following approach in 4×4 Asset Allocation:
For each 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 rents, “roll return” futures, “carry” FX, royalties, systematic tax-managed sales of appreciated assets, work-related income, etc. While this distinction may seem artificial and ambiguous, we believe that the implications for liquidity, transaction costs, taxes, accounting, and ultimately re-allocation decisions are significant enough to warrant a separate examination of these two types of cash flow.
Next, we separate “return of capital” cash flows into two categories: liquidity and preservation. Heuristically, liquidity is quickly and easily accessible and the least volatile part of cash flow, while conservation – in particular, inflation protection — is fueled by potentially more volatile investments that should hold their true value if held for longer periods.
We also divide “return on capital” cash flows into income and growth. For us, income is the closest and safest part of the way back on capital flows, and growth is the most distant and volatile aspect of performance on capital flows.
To formalize and quantify this intuition, we apply option pricing theory. Each asset/liability is mapped to four “virtual portfolios”: Liquidity, Income, Preservation and Growth based on investor preferences. Each asset/liability contributes to – or detracts from – the four goal areas in an investor-specific way.
For illustrative purposes, imagine a wealthy individual with the strategic horizon J= 10 years and some schematic portfolio allocation derived from two sets of preferences. The former is more risk-seeking and risk-tolerant with tactical rebalancing frequency 1 year and the barrier of “substantial losses” B=15%, and the second is more risk averse with a tactical rebalancing frequency 1/52 years, or a week, and the “substantial loss” barrier of B=3%.
Based on these preferences, the same portfolio fits the four goals differently.
Examples of 4 × 4 decomposition
Additionally, we offer advanced portfolio construction techniques to build investor-specific strategic and tactically rebalanced optimal 4×4 portfolios.
Strategic investment horizon J and tactical rebalancing frequency τ
Investors who focus solely on nominal dollar asset prices often overlook one or more of the four objective categories. Even asset-rich individuals and institutions can suffer from cash flow or liquidity problems, especially in turbulent market conditions. This can lead to fire sales of assets at depressed prices. Other investors may be too risk averse and miss opportunities to grow their assets or hedge against inflation. Still others may be prone to myopia and fail to balance their strategic and tactical goals and risks in a disciplined manner.
With explicit strategic portfolios, rebalanced at tactical frequency to realign with strategic objectives and take advantage of near-term opportunities, our 4×4 asset allocation is a well-suited framework for building 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, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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