A strategic investment strategy backed by a comprehensive financial plan can help provide comfort in a volatile market. Below, we explore how asset allocation should be customized to an individual’s goals and risk appetite.
Establishing Goals
One of the most important steps to building asset allocation is to establish goals, along with a timeline, with one’s financial team. There will likely be multiple goals that are top-of-mind at the beginning of any discussion of asset allocation. Creating an outline will help in prioritizing them and discussing risk tolerance.
Understanding Risk Tolerance
When determining risk tolerance, a financial team generally seeks the least amount of risk that must be assumed to achieve the goals within the stated time horizon. As the holding period of the S&P 500 is extended, the less volatile the annualized returns become. By the time it reaches 15-year holding periods, it’s a reasonably flat line.
The statistics play out in the table below:
| Holding Period | 1 Year | 3 Years | 5 Years | 10 Years | 15 Years |
|---|---|---|---|---|---|
| Average Annualized Return | 9.26% | 8.08% | 7.68% | 7.18% | 6.64% |
| Max Return | 53.71% | 30.07% | 26.18% | 16.75% | 15.74% |
| Min Return | -44.76% | -17.28% | -8.48% | -5.08% | -5.86% |
| Batting average | 73.8% | 84.6% | 84.4% | 92.4% | 96.3% |
Source: UMB Internal Data
As the holding period is extended, the extreme results begin to mute, with best and worst results becoming less extreme. Additionally, the batting average (the percentage of positive returns) increases. By the time of reaching an average 15-year holding period (see chart), there will have been a loss of money only 3.7% of the time, most of which will have occurred during the depression.
Another important distinction is one’s ability to take risk. Those who have established a larger base of investable assets will likely have more options than those who are just beginning their investing journey.
As risk tolerance may change as one journeys through life, this should be discussed as part of a regular financial review so items can be adjusted as needed.
(Note: All investments involve risk, including the possible loss of principal. Past performance is no guarantee of future results.)
Customizing the Asset Allocation
Once goals, timeline and risk tolerance have been established, it’s time to build the asset allocation.
This graph represents possible portfolios available in terms of annual return as well as risk (or variation) around that average annual return. For example, if the goals require a 6% average return, a lower bound can be set that excludes portfolios that won’t meet those goals.
If the profiling process establishes a 12% annual volatility limit, this creates another constraint on portfolio choices. is the planning might come down to a single portfolio in the unshaded area that will both meet the return goals as well as stay within the risk parameters. This is how financial planning and preference profiling interact to allow advisors to deliver a customized solution.
Any strategic asset allocation should include a blend of asset classes that reflects both risk tolerance and the timeline given to achieve specified goals. Following are a few of the most used:
- Stocks (S&P 500 and private equity): Stocks are often the highest return and highest risk asset class, depending on the time period. They will generally be the driver of growth over time and have sensitivities to economic cycles and geopolitical events.
- Bonds: Bonds are debt instruments (IOUs) issued by companies, governments and, sometimes, special purpose vehicles. They generally provide a stable income stream with a return of principal. Depending upon the credit rating of the issuing entity, the interest rate paid to investors varies — the greater the risk, the greater the return.
- Real Assets: Real assets are investments in real estate, infrastructure and natural resources, but can generally be thought of as items one can “touch.” Depending upon the particular investment, real assets generally provide inflation protection and/or a growing income stream.
- Alternative Investments: Alternatives don’t neatly fit anywhere else, but can include items like:
- Managed futures, which attempt to profit from the trends that appear in asset prices;
- Insurance-linked securities, which provide profits like that of an insurance company’s balance sheet; and
- Litigation finance, which provides profits from large class-action lawsuits.
- Private Investments: These include items like private equity and credit, real estate, natural resources, infrastructure and hedge funds. While available only to those with substantial resources (individuals with more than $5 million in net worth and organizations with more than $25 million in assets), they can provide an additional return above and beyond the liquid versions of each of the aforementioned asset classes.
Going through these asset allocation details with a financial team will ensure a higher level of understanding as investments are selected and put to work for the individual.
Daniel (Dan) Kieffer is director of asset allocation of UMB’s family office services. He joined UMB in 2022 and has nearly two decades of financial industry experience. He earned his Master of Science in finance from University of Cincinnati and is a Chartered Alternative Investment Analyst®.