Equity Investment Across The Passive ...
The choice between managing a portfolio of equities passively or actively involves... Read More
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.
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:
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:
- Mental accounting,
- Asset location,
- 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.
Portfolio Construction: Learning Module 4: Overview of Private Wealth Management; Los 4(k) Recommend and justify portfolio allocations and investments for a private client