asset dedication

Asset Dedication Part I: The Goal-Driven Investment Approach

There are various investment theories applied to portfolio management approaches. The most popular is the asset allocation approach that is based on modern portfolio theory (MPT).

However, institutional investors very often use the asset dedication approach that derives from dedicated portfolio theory (DPT), which also is utilized by IncomeClub.

 The Asset Allocation Approach

Traditional asset allocation became a modern paradigm of investment approach in the late 1980s. Based on modern portfolio theory, traditional asset allocation suggests that 90% of variations in a portfolio’s return could be explained by the way the assets were allocated in three major asset classes: X% in stocks, Y% in bonds, and Z% in cash.

The magical XYZ formula is a distinguished model used by investment advisers throughout the industry today.

Mainstream wealth management firms have widely adopted asset allocation. Indeed, money investing by asset allocation provides investment advisors easy settings and control of clients’ portfolios.

Wealth management advisors simply classify investors into three broad categories: conservative, moderate, and aggressive, and allocate a percentage of their assets across stocks, bonds, and cash using simple, predetermined formulas.

When a client opens an investment account, an investment advisor asks him to complete a questionnaire that is supposed to determine in which category a client should be placed and the magical XYZ formula is recommended.

“Gut Feel” Formula

Usually, an investment advisor who is too busy to sell his financial investment services and has no time to determine the client’s needs, uses a widespread simple “gut feel” formula, which states that 5% of assets should be allocated in cash, the bond allocation percentage number should be equal to the client’s age, and the rest should be invested in equities.

Financial advisors then tell clients that their portfolio allocation should be rebalanced to stick with determined formulas at least annually.

Some “robo-advisors” offer rebalancing more frequently (quarterly, monthly, and weekly) to remove short-term imbalances.

The magical XYZ formula of the asset allocation model is an aspect of the wholesale approach in investment advising, which does not take into consideration personal circumstances of the particular client, but attempts to simply place the client’s profile in one of the predetermined categories.

The Asset Dedication Approach

The asset dedication approach, which looks at clients’ needs from a different angle, has a fundamental difference from traditional asset allocation. Asset dedication principles are based on dedicated portfolio theory and are applied to the portfolios matching future cash outflows.

The asset dedication approach was invented during research by Dr. Stephen J. Huxley, Professor of Information and Decision Science at the University of San-Francisco, and his partner Brent Burns, a research fellow at the University of San-Francisco.

Based on this research, they wrote  “Asset Dedication: How to grow Wealthy with the next generation of asset allocation”. It was published in 2005.

The asset dedication approach dedicates specific assets of the individual to his/her specific goals. The portfolio is also divided into three asset categories: cash, bonds, and stocks.

Once specific goals are defined, the asset allocation proportion is no longer based on some magical XYZ formula, but instead based on exact goals, which should be achieved by investment portfolios.

Research demonstrates that money invested in a dedicated portfolio of individual bonds provides predictable returns and immunization from major systematic risks.

Asset dedication is the next step to traditional asset allocation.

The popularity of asset allocation began with a 1986 paper by Brinson, Hood, and Beebower. In their work, they eliminated the performance of 91 pension fund managers over 10 years from 1974 to 1983. The result was that active portfolio management has led to a lower return compared to the passive management style.

Research has shown that simple investment in stock and bond indexing funds without changing anything would have returned an average 10.1% per year; however, active involvement of the managers to time the market finally provided an average return of 9.0% per year.

This means that the market timing approach lost 1.1% in a year plus management and expense fees.

Therefore, one of the basic tenets of Asset Dedication is that an individual’s assets, besides a specific amount of cash, should be invested in full in bonds and stocks for a period of time.

Individual investing should be done without active rebalancing and market timing.

Bonds Help to Invest with a Specific Target Date

Another cornerstone of asset dedication is that only money invested in individual bonds provides predictable returns in the form of interest payments and maturity redemption.

Therefore, the fixed income allocation of the dedicated portfolio should match investors’ goals for a specific time horizon 100%.

It might be a specific amount of annual cash outflow or a specific amount of funds needed to be withdrawn in bulk at a certain moment of the investor’s life.

The unique feature of a bond is a maturity.

Regardless of price fluctuation during the holding period, a bond pays its face value in full at maturity, and you potentially never suffer a loss of capital investing in quality bonds and holding them until maturity.

Bond funds do not have maturity; thus, money invested in bond funds does not provide protection in case of an interest rate hike.

Invest in Stocks After All

The growth portion of an individual’s portfolio in stock investing should be determined after cash is set aside for potential immediate needs and bond portfolios are allocated.

The arithmetic average of stock returns during the period of 1928-1915 is 11.41%. The arithmetic average of 10-year T-bonds returns during the same period is 5.23%.You can look at raw data from Federal Reserve database here.

It is commonly recommended that the growth portion of a portfolio should be invested in equities; however, this assumption is made based on less than 100 years of history.

Although stock investing provides long-term historical return two times greater over bond investing, stock investing does not provide predictable returns and individual stock investments may suffer a significant decline during the stock market turmoil.

Diminishing Investment Return

For instance, the same statistic shows that arithmetic average return of the S&P 500 index for the period 2006-2015 was only 9.03%, but the return of the 10-year Treasuries was 5.16%.

The evidence points to the fact that the years of high returns American investors experienced was actually outside the norm.

With dropping inflation and interest rates, increasing growth and burgeoning business success created a golden age of investment. It did not last, though.

Experts now predict that if the forces that initially created the booming economy do not evaporate completely, they will have limited impact on investment return. Peak valuation has been hit, and the roller coaster is dipping downward.

The Three Steps of Asset Dedication

From the asset dedication point of view, you should do the following:

  • Set aside a minimum amount of cash to meet your immediate needs in case of an emergency. Typically, it is good to have free cash to cover at least six months of your expense outflows.
  • Create your financial goals for next 5-10 years, which must be achieved with a probability of 100% and allocate your assets in individual bonds.
  • The rest of your assets should go in the stock market for capital growth over the long term. Be aware, while the stock market provides great opportunities for a high return, at the same time, it is not guaranteed and past historical high returns may not be repeated in the future. The best way to have exposure in the stock market is investing money into and index exchange-traded fund (ETF) with a low expense ratio.

The financial industry divides the personal capital lifetime into three phases: accumulation, distribution, and transfer.

Each phase has its own investment goals and different investment strategies. However, every single dollar you have in your investment accounts should be invested with a particular goal.