Revising Asset Allocation

Real-world asset allocations seldom remain static throughout the entire lifecycle of a portfolio. Analysts are advised to reassess asset allocation regularly. Analysts can run these reassessments at least annually and after significant events like market volatility or significant changes in an investor’s circumstances. Such changes may include relocating, starting a family, job loss, or receiving a salary increase. The following paragraphs outline common reasons for updating an asset allocation.

Investor Goals/Life Changes

Individuals

Individual investors often find it necessary to adjust their asset allocations due to various factors such as family planning, education and employment decisions, and retirement planning. As mentioned earlier, these updates are prompted not only by changes in financial assets and liabilities but also by significant events that extend these assets or liabilities. For instance, a lawsuit can create an extended liability for an investor, limiting their risk-taking capacity and potentially requiring an immunization strategy. Conversely, unexpected news of a substantial inheritance would increase the investor’s risk tolerance and ability to take on more significant risks in their portfolio.

Institutions

Institutions operate the same way as individual investors. Nevertheless, their goals and considerations often revolve around the business cycle. Changes in institutional objectives are commonly influenced by factors such as the economic environment. For instance, during an economic downturn, an endowment may experience a decrease in donations, leading to the need for a reduction in portfolio risk to meet the increased drawdown requirements. 

Portfolio Constraints

Portfolio constraints refer to the limitations on the level of risk that can be taken in a portfolio. These constraints include tax considerations, time restrictions, legal requirements, liquidity needs, and other factors.

It becomes necessary to reassess the portfolio’s asset allocation whenever there are alterations in these circumstances. For instance, changes in funding regulations for endowments or private foundations may require reconsidering the allocation strategy. Likewise, a company facing escalating pension costs might be compelled to implement an early retirement program, necessitating a revision of the portfolio’s risk exposure. In addition, unexpected events, such as an individual investor having to invest in a new roof for their house unexpectedly, can also prompt a reevaluation of the asset allocation plan.

Change in Beliefs

The foundation of any asset allocation strategy relies on a set of capital market expectations. These expectations can change gradually or experience sudden shifts, similar to what occurred in 2008. Whether the changes pertain to the anticipated return, risk, or correlation among portfolio assets, any adjustments in these expectations will inevitably pull the portfolio from its optimal allocation. 

Question

Which of the following is most likely to prompt a change in asset allocation due to investor constraints?

1. An unprecedented and extended period of zero inflation.
2. A major overhaul to capital gains tax laws.
3. A spouse completing a Ph.D. and being hired as a tenured professor.

Solution

The correct answer is B.

Certain classes may be restricted by burdensome tax regulations, which are subject to change. An example could be higher long-term capital gains tax rates, which would likely shift the allocation to seek more income through interest and dividends.

A is incorrect: It is addressed in the previous section regarding changes in asset allocation due to beliefs. Although rare, a prolonged period of zero inflation can lead investors and analysts to reassess their capital market expectations. Assuming that this low inflation period will persist indefinitely might be overly optimistic. In response, investors are likely to adjust their asset allocation by increasing exposure to asset classes that perform well during inflationary periods, such as Treasury Inflation-Protected Securities (TIPS) and specific equities.

C is incorrect: It represents a significant life change. When a spouse completes a Ph.D. and secures a tenured professor position, it introduces an extended asset as a stable income, similar to bonds. In such a scenario, all else being equal, the couple now has the added security of a second income, which should lead to an increased allocation to riskier assets.

Asset Allocation: Learning Module 5: Asset Allocation with Real-World Constraints; Los 5(c) Recommend and justify revisions to an asset allocation given change(s) in investment objectives and/or constraints