Putting Bonehead Asset Allocation Behind Us

Towards Equilibrium, Differentiated Portfolio Advice

Kurt Winkelmann, Raghu Suryanarayanan, Ferenc Szalai

The use of portfolio choice models to advice investors on asset allocation is a ubiquitous feature in the investment landscape. Although practitioners seemingly embrace the idea of customized portfolio advice, many of these models effectively treat investors as being homogeneous. Moreover, the disposition of the investment assets is treated separately from the savings decision. One immediate consequence of this approach is that there is a one-size-fits-all to the positioning of investment strategies.

This note explores an alternative. That alternative takes seriously the ideas of capital market equilibrium, heterogeneity across investors and the importance of managing macroeconomic shocks. In our opinion, adding these offers a systematic way to provide more extensive portfolio advice. That advice explicitly moves away from the blunt force of one-size-fits-all investment strategies. Fortunately, many of the analytic tools and databases are available to implement this approach right now.

A convenient place to start the discussion is with the market weights of an identifiable subset of all assets, as shown in Exhibit 1. It is a convenient starting point because workhorse asset pricing models such as CAPM hold that all investors should hold some combination of the market portfolio and a riskless asset. 

Exhibit 1 - Investable Global Market Portfolio

Investable Global Market Portfolio
Source: Navega Strategies LLC Research, BIS, MSCI, Burgiss

A relevant next step is to examine who holds the assets. Exhibit 2 illustrates the aggregate holdings of assets by broad investor category. Several observations are in order about the data in Exhibit 2:

Exhibit 2 - Global Asset Holdings By Investor Type

Global Asset Holdings By Investor Type
Source: Navega Strategies LLC Research, Willis Towers Watson, Pensions & Investments, Sovereign Wealth Fund Institute, Cap Gemini, Statista

Given that there are known differences between objectives and constraints, it should not be at all surprising that asset allocation choices and rebalancing rules differ across investor types (e.g., life insurance companies versus defined benefit pensions). The question is whether there are any insights to be gained by explicitly incorporating these differences into asset allocation processes.

The key questions for identifying potential gains are the following: first, does the sum of the individual asset allocation decisions add up to the observed aggregate market portfolio; second, do the distributions (e.g., large cap versus small cap stocks) in the aggregated portfolio match those of the market portfolio.  

Central to making this approach work is being explicit about the behavior of each individual investor type. To generalize, portfolio theory tells us that conditioned on paths for asset returns and income/revenue (or contributions) and constraints, investors choose paths for savings, consumption/spending and investments. The equilibrium point is that these sequences must add up to both aggregate savings and aggregate market cap weights for each specific asset class. Thus, to give sensible advice, we must be specific about the income/revenue and asset returns processes, and constraints that are specific to each investor class.

To illustrate some of the main points, let’s look at a simple example. To facilitate discussion, we’ll assume that there are only individual investors.  There is a distribution of these investors across the lifecycle. Each investor is assumed to work until age 65, at which point they retire. During their working years, they save for retirement out of current income, and invest in a combination of risky and risk-free assets. Once they retire, they consume out of accumulated investments. 

The main choices for each individual are: how much to consume across the lifecycle; how much to save during working years; the split between risky and risk-free assets across the lifecycle, and the allocation of risky assets across the lifecycle. We’ll assume that each individual investor solves a unique lifecycle portfolio choice problem to arrive at a glidepath for asset allocation choices across the lifecycle. We’ll also assume that each investor takes as given a set of expected asset returns, as illustrated in Exhibit 3. (The figures in Exhibit 3 show long-term premiums for macro growth-sensitive and macro growth-defensive factors).

Exhibit 3 - Long-Term Expected Returns

Long-Term Expected Returns
Source: Navega Strategies LLC, Returns As of September 30th, 2021

Exhibit 4 shows the allocations to bonds and equities (in terms of growth-sensitive and growth-defensive factors) across the lifecycle. By taking the weighted average of the wealth accumulated at each point in the lifecycle, we arrive back at the original capitalization weights for each asset class. Similarly, in asset pricing equilibrium, the weighted average of the expected returns for each asset class should sum to the original expected returns.

Exhibit 4 - Navega Model Implied Asset Allocations By Investor Age Group

Navega Model Implied Asset Allocations By Investor Age Group
Source: Navega Strategies LLC Research

The important point in Exhibit 4 is that investors vary in their allocation to growth-sensitive and growth-defensive premiums. In this example, younger workers have higher allocations to growth-sensitive factors, while retirees have higher allocations to growth-defensive factors. Thus, differential portfolio advice has a sound economic basis.

An often-unrecognized challenge for investors is to distinguish between the wisdom and the pull of crowds. The main question that investors should ask about every investment opportunity is who is taking the other side of the bet. For every investor who chooses to overweight an asset class (relative to market capitalization weights), there must be an investor who chooses to underweight. The approach that we’ve outlined in this note provides a solid foundation to begin to better analyze and address this issue, and therefore provide better, differentiated portfolio advice.

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