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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. 

Morningstar's Christine Benz shares Chhabra's view. She writes, "I am a fan of bucketing because the framework helps people get off the 'income only' kick, which in my mind is the single most worrisome behaviour that retirees exhibit these days. They have portfolios full of MLPs, preferred stocks, junk bonds, foreign bonds, and all of this other gobbledygook, all in the interest of generating a liveable yield. A bucket strategy helps people visualise what a total return portfolio should look like." Here, you can see John Ameriks of Vanguard, financial adviser Harold Evensky, and Christine discuss the benefits of buckets. For more on buckets, read Michael Kitces' blog. 

Being pragmatic by nature, I concur. (Apparently, Markowitz himself also doesn't see the need for pure science, as he once stated that he owned a portfolio made up of half stocks and half bonds so that he wouldn't feel regret for holding the wrong asset.) That said, it's important to acknowledge the other side of the argument. Buckets appeal from the broad perspective but are trickier to implement because they have more moving parts. They also are arbitrary and less conducive to sensitivity testing, which undermines the discipline of the allocation process. Pragmatism does come at a cost.

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About Author John Rekenthaler

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