Investor's Alpha: Proper Asset Allocation

by: Adam Hoffman, CFA


Proper asset allocation is a dynamic process and not just the end result of the mixture of stocks, bonds, and cash.

Asset allocation should be guided by the investors objectives and constraints, not headlines or top mutual fund lists.

Asset allocation aligns the risk tolerance of the investor with the risk of their portfolio.

Investor controlled inputs in the investment process will be an important driver of increasing returns in a low return environment. On a pessimistic note, Peak Capital believes that returns over the next five to ten years will be quite muted with a 60% Stock and 40% Bond portfolio returning ~3%. On an optimistic note, wealth creation is not entirely dependent on market returns. Investor controlled actions can help improve portfolio outcomes. For readers of our 2017 Economic Outlook or our previous Investor's Alpha papers, wealth is dependent on two factors:

Wealth = Factors You Control + Investment Returns

Focusing on investor controlled inputs will be the key to enhancing low market returns:

  • Savings Rate & Spending Rate
  • Systematic Portfolio Rebalancing
  • Proper Asset Allocation
  • Tax Management
  • Proper Asset Location
  • Investment Expense

In this part of our Investor's Alpha series, we will focus on the importance of proper asset allocation in improving portfolio outcomes. At its most basic level, asset allocation is the mixture of stocks, bonds, and cash in an investment portfolio. Stock, bonds, and cash are the primary asset classes. Asset allocation for a portfolio or for a mutual fund is usually represented via a pie chart with colorful slices representing various asset classes.

In this paper, we will outline the process of arriving at a proper asset allocation as well as the benefits of a properly allocated portfolio.

Asset allocation is not just an end result; rather, it is a dynamic process that is driven by investor's objectives and constraints. Asset allocation should not be viewed as a RonCo product where "you set it and forget it"; rather, asset allocation should be viewed as a piece of computer software that requires periodic updates. An investor's asset allocation should be guided by their return objectives, risk tolerance, time horizon, tax situation, liquidity needs, legal or regulatory constraints, and unique circumstances (RRTTLLU). As these inputs change, so should the allocation of the portfolio. At Peak Capital, we catalog these inputs into our client's Investment Policy Statement (IPS), which is a living, breathing document that guides the portfolio construction process. By basing investment decision on the IPS, this is likely to lead to better portfolio outcomes, because performance chasing and trying to predict the markets are losing proposition. In addition, the IPS provides a firm foundation for taking investment action, which also helps reduce cognitive errors and emotional biases.

The asset allocation's primary objective is to align the risk profile of the investment portfolio with the investor's objectives and constraints: return, risk, time horizon, tax situation, liquidity needs, legal constraints, and unique circumstances. It is important in the asset allocation process that these RRTTLLU's are properly incorporated to produce a proper asset allocation.

Below we present an abbreviated summation of objectives and constraints. A deeper examination of RRTTLLU can be found here or on our website.

Return Objective

  • Why is the money being invested?
  • Rate of return required to achieve the goal based upon savings rate - is this return feasible given expected returns?
  • Differentiate between required and desired return

-i.e. flying commercial to visit family versus chartering a plane

Risk Tolerance

  • Willingness: qualitative assessment of an investor's psychological profile

-Typically assessed via a Risk Tolerance Questionnaire

-The sleep test: how much could you lose, before not being able to sleep at night

  • Ability: quantitative assessment of the portfolio's ability to take on loses and still meet the investor's critical goals

Risk tolerance is set at the lower of the investor's ability or willingness to take on risk

Time Horizon

  • When will the money be needed?

-Short, intermediate, or long-term

  • How long will the money need to last?

Tax Situation

  • What tax bracket is the investor in?
  • What methods are available to reduce tax liability?

-Tax avoidance is the goal and not tax evasion, an illegal act

  • Gift or wealth transfer taxes

Liquidity Needs

  • Emergency Fund to at least meet 3 months of living expenses

-Reduces the chances of having to sell part of the investment portfolio at an inopportune time

  • Portfolio's ability to meet anticipated income needs
  • How reliant is the investor on the portfolio to provide money to meet required needs? i.e. are there other sources of income: pension, social security, etc

Legal / Regulatory Constraints

  • Usually very little legal or regulatory constraints for investors
  • Does a trust outline specific requirements? i.e. disbursements
  • Gifting or wealth transfer restrictions imposed by law or tax authority

Unique Circumstances

  • Restrictions or mandates on investment strategy

-Social, green, no vice etc.

  • Restrictions on sale of company stock
  • Bequests

The primary determinants of risk for a portfolio are going to be risk tolerance, time horizon, and liquidity needs. Tax, legal, and unique circumstances are constraints that may limit the investible universe, which will require an adjustment for calculating expected market returns in determining if return objectives are reasonable. Risk tolerance can be broken down to the "stomach & wallet". Is the investor able to "stomach" loses and can the "wallet" afford to lose money and still meet critical needs. A longer time horizon until money is needed allows for the portfolio to take on more risk, and vice versa. The more dependent an investor is on the portfolio to meet their liquidity needs, the lower the ability to take on risk. i.e. the portfolio cannot afford to take on risk, because the portfolio would need to be invested in assets that have predictable prices to meet future liquidity needs.

These seven inputs should be the driver of the asset allocation for a portfolio. If there is a change in an investor's circumstances that changes the objective of the portfolio or its constraints, then a change should be made to the asset allocation. The investment process should be driven by the investor and not the markets or the news headlines. Nobody can successfully predict the future nor time the markets, and a properly constructed asset allocation and investment plan will help avoid knee-jerk reactions to the markets. For example, if an investor had a 50% Stock and 50% bond portfolio during the housing market crash and then made an extreme transition to an all bond or all cash portfolio, it would have taken nearly 5 years for the all bond portfolio to get back to even and the all cash portfolio would still have a negative return (Figure 2)[i]. Had the investor remained in the portfolio 50% Stock and 50% bond portfolio, these loses would have been recovered in approximately a year and a half.

It is important to note that RRTTLLU will change over time and with an investor's experience. An investor's willingness to take on risk may have certainly changed after seeing a ~50% decline in the stock market. If that is the case, a change in the in asset allocation would be dictated by a change in one of the inputs, risk tolerance. On the other hand, if the investor is still willing to take on the same amount of risk after the stock market decline, then maintaining the allocation would still be prudent since there would be no change to an input the process.

In addition, a portfolio that is not properly aligned with the investor's constraints can lead to significant underperformance. The goal of the process of properly allocating a portfolio is not necessarily to make great investment selection or capture additional alpha; rather, the goal is to align the risk of the portfolio with the tolerance of the investor to mitigate behavioral reactions. A recent study by DALBAR examines 20 years of investor returns and found that the "average" investor underperformed by ~3.5%(Figure 3)[ii]. More than half of that underperformance could have possible been reduced by having a properly allocated portfolio: need for cash (planned and unplanned) and voluntary investor behavior.

At Peak Capital, we maintain that investor controlled inputs will be the primary drivers of wealth creation in a low return environment. We maintain that proper asset allocation is a dynamic process and not just the haphazard result of combining stocks, bonds, and cash. Having a process in place to drive asset allocation can help mitigate psychological reactions to the market and the temptation to chase performance or time the markets. Peak Capital urges all investors to start the process of investing with taking an honest look at their objectives and constraints and then allowing these to drive the investment process. We fully acknowledge that the process of crafting a proper allocation can be tedious, but we believe that the process can drive better portfolio outcomes.

We hope our Investor's Alpha series is helpful to you, the investor, or to advisors in communicating with your clients. Any questions or feedback is always appreciated.

Adam Hoffman, CFA, CAIA

[i] Vanguard Group. (2016, December). "Your Financial Advisor: Bringing Value Through Advice". Retrieved via

[ii] DALBAR. (2016, April). "Better Investment Recommendations Equals Greater Returns?: DALBAR Annual Report of Investor Returns Says Not So". Retrieved via

Disclosure: I am/we are long VTI, VXUS, VCSH, VCIT, VMBS, VFIIX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Peak Capital Research & Management's clients are long the following positions in either Vanguard ETFs or Mutual Funds or utilizing a similar iShares ETF. Broad US Index, Broad International Index, short-term corporate bonds, intermediate-term corporate bonds, and GNMAs.

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Tagged: Financial Advisors, Wealth Management
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