Portfolio Allocations and Investments

After creating the IPS wealth managers need to decide on an asset allocation that best fits the clients' objectives and constraints. This section covers 2 main approaches to asset allocation selection.

Traditional Approaches

The traditional approach is the most used. Goals-based approaches are also used, especially in the case when clients may have low standard of living risk and the presence of emotional biases. The traditional approach involves several steps, outlined below:

• Identify asset classes: To recommend an asset class, a manager must have a way to segment, and identify asset classes. Asset classes must be mutually exclusive and exhaustive to work properly.
• Develop capital market expectations: Taking into account the client's investment horizon, the wealth manager examines the expected returns, standard deviations, and correlations of asset classes.
• Assess constraints: Clients often have limitations such as ESG investing, avoiding real estate due to a large portion of their net worth already invested in their primary or secondary residence, or potential tax considerations. These may limit the available investment universe, to the extent they exist.
• Determine portfolio allocations: Mean-variance optimization (“MVO”) is a popular method. MVO can identify the portfolio with the highest Sharpe ratio, after having considered the investors limitations.
• Implement the portfolio: At this stage, the wealth manager faces several decide to implement the portfolio using:
  • Active management or passive management (e.g., indexing) for each asset class. Once that decision is made, manager selection becomes an important consideration.
  • Exposure to certain investment factors like “value” (value stocks over-growth stocks) and “size” (small-capitalization stocks over large-capitalization stocks).
  • Decision to utilize individual securities or pooled vehicles, such as mutual funds and ETFs.
  • Finally, the decision to apply currency hedging, or not.
• Determine asset location: This decision arises when clients have multiple accounts. Generally, tax considerations are a critical factor for asset location. If certain accounts offer unique tax benefits (e.g., tax deferral), the wealth manager will generally allocate less tax efficient holdings to those accounts, and vice versa.

Goals-based Investing

Goals-based investing builds on the idea of mental accounting, which is itself a behavioral bias, well-known in finance. The idea is to divide the portfolio into sub-portfolios and create an asset allocation for each individual goal.

The tradeoffs involved are that this type of analysis does not consider correlations among the sub-portfolios (it is not MVO). The positive side is that clients may be more likely to both understand, and stick with the investment plan. The following table gives a quick example of such a setup.

$$ \begin{array}{l|r|r|r}
\text{Dec 31, 20xx} & {\text{Sub Goal 1}} & \text{Sub Goal 3} & \text{Total} \\ \hline
\textbf{Asset Class} & \text{Vacation} & \text{Retirement} & \text{Portfolio} \\
& \text{Property} & & \\ \hline
\text{Alternatives} & 30\% & 0\% & \bf{15\%} \\ \hline
\text{Equity} & 50\% & 35\% & \bf{43\%} \\ \hline
\text{Bonds} & 15\% & 60\% & \bf{38\%} \\ \hline
\text{Cash} & 5\% & 5\% & \bf{5\%} \\ \hline
\textbf{Total} & \bf{100\%} & \bf{100\%} & \bf{100\%} \\ \hline
\text{Expected:} & & & \bf{0\%} \\ \hline
\text{Return} & 15\% & 8\% & \bf{12\%} \\ \hline
\text{Standard Deviation} & 17\% & 5\% & \bf{11\%} \\
\end{array} $$

In the example above, an equal-weighted portfolio is shown, with the resulting portfolio expected return and standard deviation, which are simple weighted average. This type of analysis does not consider the correlation between the portfolios, and therefore will tend to overstate the portfolio risk. This leads to calculated portfolio Sharpe ratios which are actually worse than they appear, and may lead to overly conservative investment choices. Choosing overly conservative portfolios leads to a potential to leave the goals underfunded, or unmet.

Question

Goals-based investing builds on the concept of:

1. Mental accounting,
2. Asset location,
3. Statement of client risk tolerance.

Solution

The correct answer is A.

As it relates to portfolios, mental accounting is the process of dividing portfolios into sub-portfolios, rather than viewing wealth in a wholistic manner. This is problematic in that it does not consider correlations among sub-portfolios.

B is incorrect. Asset location refers to choosing which accounts certain asset class weighting will go.

C is incorrect. Statement of client risk tolerance is a section within the IPS that explains how much willingness and ability a client has to tolerate risk. This will inform the asset allocation decision, but is not related to the choice of using goals-based vs traditional approaches to asset allocation.

Reading 7: Overview of Private Wealth Management

Los 7 (l) Evaluate and recommend improvements to an IPS for a private client