Asset Allocation and Buckets

REKENTHALER REPORT: Should portfolios be built strictly by the numbers?

John Rekenthaler 30 May, 2013 | 4:45PM

In a previous post, I mentioned Merrill Lynch's move toward "goals-based" advice with the appointment of its new CEO, Ashvin Chhabra.

Chhabra's position paper on the subject, "Beyond Markowitz", is notable for its use of allocation buckets. Chhabra recommends that investors separate their assets into three groups. The Personal Risk group consists of a residence and cash and is intended to provide for basic needs. The Market Risk group consists of roughly the standard 60/40 equity mix and is for maintaining the investor's lifestyle. Finally, the Aspirational Risk group consists largely of alternative assets such as options and hedge funds, with the goal of enhancing the investor's lifestyle. (This could also be called the Three Bears approach.) 

This recommendation runs counter to the advice of Nobel Laureate Harry Markowitz, which holds that optimal asset allocation is conducted across an investor's entire portfolio, rather than done over different bits and pieces. Investment mathematics unambiguously support Markowitz's contention. But psychology leans the other way, as investors intuitively tend to think in buckets--first, providing for basic safety (Personal Risk); second, making a profit with additional sums (Market Risk); and then third, if the investor is fortunate enough to be wealthy, taking fliers with house money (Aspirational Risk). Chhabra labels this framework as "pragmatic"--a word that acknowledges his swap of theoretical accuracy for practical comfort. 

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John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.

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