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A Unique Approach to Asset Allocation

If you work with an advisor, chances are you have had a great deal of communication around risk tolerance and risk appetite. Whereas risk appetite is your feelings toward risk, tolerance is the physical measurement of risk you can take and still reasonably achieve your goals. At CPWM, we hear all too often from new clients that they have only ever taken a risk assessment questionnaire as it relates to their investments and the corresponding asset allocation. While this is an effective tool to gauge an investor’s risk appetite, it could fail to quantify risk tolerance. Too much focus on either one of these types of risk can lead to serious problems down the road.

Liability-Driven Investment

To combat the issue of too much focus on risk appetite, we work with our clients to develop a liability-driven investment strategy. To accomplish this, we fixate on the cash flows of each client as follows:

  1. Are you working or retired? If working, when would you like to retire and/or when do you think you can?
  2. What sources of income do you have outside of the portfolio?
  3. What amount of Social Security benefits can you expect to receive and how can you be strategic with when to start collecting?
  4. Are there any one-time windfalls (i.e., sale of business, inheritance, legal settlements, etc.) that you can conservatively plan for?
  5. What are your fixed expenses annually?
  6. What do you spend on average for discretionary items (expenses that can be dialed back if needed)?
  7. When will your debt service payments end?
  8. When will taxes on the portfolio (required minimum distribution [RMD], capital gains, etc.) meaningfully increase your annual spending?
  9. Are there one-time expenses (down payment, wedding, birth of a child, etc.) you need to prepare for?   

The answers to all of these questions, and many more depending on your specific situation, assists us in projecting the annual liability (total net income minus total expenses) for a given year. Once armed with this knowledge, we are able to clearly see what the probable liability on a portfolio would be for a number of periods far into the future—and then we seek to protect that estimated liability using the portfolio’s asset allocation. Unlike using a risk assessment questionnaire, our process actually quantifies the amount of risk we can take within the portfolio. Couple this approach with a robust discussion around risk appetite and we arrive at a unique asset allocation that we believe fits each client’s specific needs and that is intended to help clients in accomplishing their goals, but most importantly, allows them to sleep easy.

Target Date Funds

We get a lot of questions about the use of target date funds for managing clients’ allocation and retirement planning. In most cases, we have found the cookie-cutter allocation doesn’t meet the needs of our clients. These funds arbitrarily increase their allocation to more conservative investments the closer we get to the target date and leave clients with allocations that we believe are too conservative to achieve their goals (see below).

To make matters worse, target date funds typically have a higher expense ratio than if you were to build the allocation with the individual component funds. Said differently, you pay a premium for an investment manager to give you an allocation that likely doesn’t suit your needs.

We fundamentally believe in our approach to asset allocation. When working with clients, we can easily point to our analyses and explain to them exactly why they are allocated the way they are. This is especially important in times of high volatility, when clients are frequently looking for reassurance about the allocation we have in place. We welcome the opportunity to show you what a CPWM portfolio might look like for you.


Image source: Vanguard

Important Disclosure Information:

Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.